In recent columns I have focused on the merits of Brexit and why the market has been so wrong in its initial reaction to the result. Regular readers and visitors to my website will have noted I have added to equity positions within respective portfolios during this volatility. It is therefore pleasing to see markets recover their poise and post new recent highs.
However, there are still sectors that are suffering from undue pessimism. One is commercial property, where sentiment has also not been helped by a number of open-ended property funds rebasing their unit pricing to reflect modest write-downs in their portfolio valuations, and then suspending trading completely following an increase in redemption requests.
This has presented investment trust investors with an opportunity as prices have retreated – one that I seized during July by adding to existing holdings of Standard Life Property Income (SLI) within both portfolios. At times like these, long-term investors would do well to remember that volatility is an opportunity rather than a risk.
Longer-term attractions
When first turning positive about commercial property at the end of 2011, I suggested the sector was in the foothills of what will prove to be a long and profitable journey – SLI was introduced to both portfolios when standing on a 15 per cent discount and offering an 8.7 per cent yield. The foothills have been left long behind, but the journey is still worth travelling.
A number of longer-term factors suggest support. At a time when good-quality yield is in short supply, with government bonds appearing to offer little value, commercial property looks attractive – particularly when held within an investment trust standing at a discount. In addition, certain sub-sectors, such as ‘industrial’, still offer value, with yields exceeding 7.5 per cent-8 per cent.
Meanwhile, a noticeable feature of this property cycle has been the lack of investment and therefore shortage of supply. When combined with an improving economy and the high cost of moving location, this is tending to feed through to rental growth – particularly for those portfolios focused on quality assets. We should remember that, over time, income has accounted for around 70 per cent of the sector’s total return.
Add in a global debt scenario that will continue to act as a drag on economic growth, thereby ensuring interest rates will remain low for the foreseeable future, and the two biggest index providers (MSCI and S&P) for the first time looking favourably upon real estate as a separate sector, and the sector’s positive long-term outlook remains intact.
Yet Brexit has ushered in a severe deterioration in sentiment, as investors anticipate declining demand in terms of both the physical and financial asset. I suggest this is misguided for a number of reasons.
But we should first address the role of the unit trust industry in this matter. Commercial property, as with other ‘illiquid’ types of investment, is not suitable for open-ended funds which, by their very nature, should allow investors to add to or subtract from the assets of the portfolio on a daily basis. Slick marketing has trumped good sense in this regard.
Furthermore, changing the unit pricing to reflect write-downs that were conducted almost as a knee-jerk reaction to Brexit, with little regard to empirical evidence, helped to feed the negative sentiment that eventually became self-fulfilling with the closure of certain funds to dealing. The industry should now reflect on lessons learned.
As for investors, we should continue to reflect on the fundamentals. In the long term, little has changed. In the short term, the Brexit jitters look overdone. The lack of new properties will soften the impact of any lessening in demand if indeed this occurs – the recent weakening of sterling may actually increase demand for UK property, as it is now cheaper for foreign investors.
Comparisons with the 2008-09 financial melt-down, which hit the sector hard, are also wide of the mark. Debt levels among the commercial property investment trusts are on average much lower than then, and UK banks are in a stronger position. The debt that does exist has been secured very cheaply in recent years on a long-term basis, with very few trusts having any medium-term refinancing requirements.
Add in fund managers’ caution and therefore lack of development exposure, their present focus on income, which is ensuring dividends are covered, and their diversification across sectors and regions, and these trusts are much better placed to weather any testing times.
Standard Life Property Income – update
Accordingly, as website visitors will know, during the sell-off in July I added to both portfolios’ existing holdings of Standard Life Property Income when priced at 67p and standing at an 18 per cent discount to the last reported net asset value (NAV) – as at 31 March – and while offering a 7.1 per cent yield. The price has since bounced, but SLI still looks attractive – standing on a 5 per cent discount and offering a 6 per cent yield at the time of writing.
My recent catch-up with Jason Baggaley, the manager, confirms that the portfolio continues to be well diversified but with an increasing focus on industrials and assets outside central London. SLI’s detailed, cautious and bottom-up approach maintains a focus on modern quality assets with the potential for rental growth which, when combined with conservative financing and decent revenue reserves, has helped to provide for a 2.5 per cent dividend increase.
Meanwhile, SLI’s recent acquisition of Jersey Property Unit Trust and its 22 properties is bedding down well. This new portfolio complements the old one well – it has a focus on industrials and offices with relatively little exposure to retail, while holding little in central London, Scotland or Wales. The slightly shorter lease profile should allow SLI to take advantage of current market conditions where supply is constrained and tenant demand is good.
As Jason and his team get to know their new tenants, they believe the portfolio provides an opportunity to enhance the income return through good asset management. This marries with their belief that the market may be at a tipping point, where capital growth from yield compression is coming to an end and returns are driven increasingly by income and rental growth – for which SLI is well positioned.
Other portfolio changes
July saw other changes to the Growth portfolio. Fidelity China Special Situations (FCSS) and JPMorgan Japan Smaller Companies (JPS) were top-sliced after reasonable runs, and City Natural Resources (CYN) was again added to – the portfolios’ growing exposure to commodities being courtesy of both conviction and price appreciation.
ABOUT THE AUTHOR:
John Baron waives his fee for this column in lieu of donations by Investors Chronicle to charities of his choice. As these are live portfolios, he has interests in all of the investments mentioned. For more portfolios and commentary please visit John's website at: johnbaronportfolios.co.uk
