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Property fund freezes suggest cycle turning, but it's not 2007

Open-ended investment companies are being caught up in the rush to exit commercial property
July 7, 2016, Emma Powell and Bradley Gerrard

The Brexit fallout has sent ripples through the commercial property market, with a number of funds holding roughly £12bn of investors' money pulling down the shutters of further withdrawals. The big question now is whether the sudden aversion by investors to anything property related is justified.

Certainly, some asset values have been cut: Standard Life (SL.), Henderson and M&G all reduced the valuations of their underlying portfolios by 5 per cent after the vote. How evidence-based this move is remains to be seen, but by stopping further withdrawals, funds are acting to prevent a repeat of the corrosive 'race to the bottom' that occurred in the wake of the Lehman crisis.

But an outflow of funds was already building up before the referendum, with investors worried that certain sectors, such as the London office market, could be hard hit by a vote to leave. And a further downward shift in valuations can't be ruled out. Analysts at Liberum are already pricing in a 10 per cent fall, while Mike Prew, analyst at Jefferies, warned the fallout could spread to real estate investment trust (Reits), which are already trading at just two-thirds of net asset value.

Analysts at Capital Economics are taking a more sanguine view. Faced with the prospect of lower UK interest rates and weak yields in gilt-edged stock, property is likely to look more attractive than many of the alternative investment opportunities, and more so if, and it is a big if, the UK economy avoids slipping into recession.

Peering through the cloud of uncertainty, even with a fall in demand for office space, notably in London, there is still likely to be a supply/demand imbalance, especially as any new speculative developments will be put on ice.

Even in the event of a 70,000 net jobs loss, Capital reckons that the ensuing vacancy rate of around 8 per cent would still be consistent with stable rents.

David Coombs, head of multi-asset investments at Rathbones, sold out of commercial property in March on the grounds that yields were "not reflective of the risk you were taking" and that the recent flood of money had "driven some funds down the quality chain", meaning they owned more 'secondary' assets - those in smaller towns and cities.

But he added the commercial property sector was not as highly geared as in 2007 and that a small correction was healthy. "I don't think commercial property is about to crash, but I think people forgot the risk they were taking as they were dazzled by the yield," he said.

James Sullivan, director at Coram Asset Management, said he had this week snapped up some real estate investment trusts, including Land Securities, which "now trade on substantial discounts to net asset value and offer yields that are once again noteworthy".

Numis said listed property investment companies on discounts above 20 per cent were a buying opportunity given the yield. Rental income and growth are key components in returns.

Elsewhere, banking stocks also weakened this week as the rush by some retail investors to exit the property market and weak construction purchasing managers' index data lumped further scrutiny on their exposure.

Secure Trust (STB) said it had "limited appetite" for commercial property lending and estimated it had only £31m in such loans. Rival challenger bank Shawbrook (SHAW) was hit again, meaning its shares have more than halved since the Brexit vote. Commercial mortgages accounted for a third of its net operating income at the end of last year. Its peer Aldermore (ALD) is also exposed to the SME commercial mortgage market, although only up to roughly 15 per cent of group operating income. Nonetheless, we have moved it to hold from buy.

It is not just the alternative lenders that look vulnerable to a downturn in the commercial property market, though. Banking giants Lloyds (LLOY) and RBS (RBS) have been focused on growing their commercial banking business - especially the latter.

For more detail on the latest funds to suspend withdrawals, click here.