Pick up growth and yield with commercial property

UK commercial property delivered a total return of 2.8 per cent in the third quarter of 2013, according to the IPD Quarterly Index. This was an improvement on 1.9 per cent in the second quarter and the highest level of performance delivered since the fourth quarter of 2010. Performance was driven by a 1.4 per cent income return and 1.3 per cent capital growth.

"It was the favourable sentiment towards property as an asset class which was the striking feature of performance in the third quarter," says George Shaw, manager of Ignis UK Property Fund (GB00B053C307). "This lifted the performance of the weaker non-London/South East/Prime markets by a significant amount."

Ignis Asset Management's total return forecast for 2013 has been increased to 10.1 per cent from 8.3 per cent in September. Ignis expects this trend to continue into 2014 as the rate at which prime and average yields continue to fall accelerates, culminating in a total return figure of 11.5 per cent for the year, more than 2 per cent stronger than the latest IPF Consensus Forecast of 9.3 per cent. Over the next three years, Ignis forecasts an annualised total return of 8.7 per cent.

"The majority of capital growth is expected to be generated by yield compression," says Mr Shaw. "This in part reflects the intensive competition for the limited number of quality assets available, as an increasing number of investors seek exposure to the asset class."

It is not only commercial property fund managers who are bullish. "We continue to be very positive about the outlook for UK commercial property in 2014," says Martin Bamford, managing director of chartered financial planners Informed Choice. "The growing economy is lifting levels of tenant demand and new building starts are at quite a low level, which should support prices. With the average yield on UK commercial property at 6.25 per cent, there is a reasonable gap between this and the current gilt yield which is hovering below 3 per cent. Commercial property should therefore generate a reasonable income for investors this year, and also offer a good prospect for capital growth."

Property offers an attractive return relative to bonds. "Cash returns are negligible and equity dividend yields are falling after the sharp rise in equity prices over the last year. This makes the sometimes derided 'boring' bricks and mortar commercial property funds with a 3 per cent yield, promise of a small capital return, low volatility and a limited threat to capital begin to look attractive," says Rob Pemberton, investment director at HFM Columbus Asset Management.

Risks

There is a risk that the market could get ahead of itself in the short term, with too much capital chasing insufficient stock, causing values to rise strongly, despite not being supported by improved fundamentals, according to Fiona Rowley, manager of IC Top 100 Fund M&G Property Portfolio (GB00B8FWH509).

Read Ms Rowley's 2014 outlook

But, while double-digit return projections may stoke fears of a bubble in the asset class, Ignis believes property yields can sustain a moderate re-rating in the near term due to relative pricing between the asset classes, combined with an improving economy, and because average property capital values remain about 30 per cent below the previous peak recorded in 2007.

But Mr Shaw remains cautious on rental growth, particularly beyond central London and certain hotspots in the south east and micro-locations. "The overall rental growth forecast figure remains modest and we would caution that a good deal of existing leases remain heavily over-rented as they approach expiry," he says.

"We remain very wary of true secondary and tertiary stock," adds Richard Kirby, manager of IC Top 100 Fund F&C Commercial Property Trust (FCPT), referring to properties situated in less prime locations. "There is still too much space in the wrong locations in all the three main sectors of the UK commercial property market."

If a tenant suddenly vacates, renting, buying or selling the property can take months. This can cause funds to lower or cease dividend payments, or sharp falls in capital values.

"Liquidity is probably the biggest risk associated with commercial property funds right now: managers have to strike the right balance between holding enough cash to manage redemptions and invest in new opportunities, and not holding too much cash which might act as a drag on performance," says Mr Bamford. "The retail sector also represents a risk to property funds as it is in long-term decline with the internet replacing high street shopping."

Investment trusts, which are listed on the stock market, do not have to meet redemptions as when their investors want to divest of their holdings, they can sell the shares. Finding a buyer could be more difficult, however, if a certain trust or commercial property is out of favour, and the trust is trading at a wide discount to net asset value (NAV). You may be forced to sell your shares for less than you bought them, and generally listed vehicles are more volatile than unlisted ones.

Direct versus equities

When choosing commercial property funds, you have two main options - ones which invest directly in offices, warehouses and shop units, or those which invest in property companies' shares.

Simon Moore, research team leader at wealth adviser, Bestinvest favours direct property funds. "The prospects for UK commercial property are now more concrete and managers forecast 9 to 10 per cent total return for 2013 and 10 to 12 per cent for 2014. So we have reversed our stance, reducing our conviction in funds of property shares and increasing the rating of our preferred physical property funds. Physical property is also a better diversifier for mixed asset portfolios than property securities, which will always have some level of correlation to broader equity markets."

Property share funds carry some of the same risks as equities, and Mr Moore says in the US market, where property equities have done well, if there is a setback, funds with exposure to that would also face a setback.

But Rob Burdett, co-head of the multi-manager funds team at F&C Investments, believes it is better to have a mix of direct property and property equity, and while Mr Moore is concerned on US-listed property equity, he says the UK and European property shares are in recovery mode, so suggests funds which offer exposure to these markets. These include TR Property Investment Trust (TRY), an IC Top 100 Fund favoured by a number of brokers and advisers, which is also one of the investment trust analysts at Winterflood's recommendations for 2014.

The trust can be picked up on a slight discount to NAV in contrast to the double-digit premiums of UK direct trusts, and yields 3 per cent. It has nearly 43 per cent of its assets in UK property shares, and 51 per cent in continental European shares, with a small exposure to UK direct property. It has beaten its benchmark, FTSE EPRA/NAREIT Developed Europe, over one, three and five years.

Property investment trusts

Source: Morningstar

Performance data as at 20 January 2014

Direct property funds

Because of the popularity of the asset class and the search for yield, nearly all the investment trusts directly invested in UK commercial property are trading on premiums to net asset value (NAV). The sector average premium for the Association of Investment Companie's Property Direct UK sector is 15.3 per cent (21 January 2014). So for direct exposure you are probably better looking to an open-ended fund.

When choosing an open-ended fund, it is best to compare them against their own benchmark rather than the Investment Management Association (IMA) property sector, as this brings together funds investing in various types of property assets. You could also compare them to the Morningstar Property - Direct UK sector, which brings together similar kinds of funds.

Bestinvest has recently increased its ratings on IC Top 100 Fund M&G Property Portfolio (GB00B8FWH509). "M&G Property Portfolio has a high quality portfolio of around 150 properties spread throughout the UK," says Mr Moore. "We place high importance on the long average lease length (11 years), low vacancy rate (2 per cent) and low tenant risk, though the high cash position (9.6 per cent) may hold back performance and dividends."

The M&G Property Portfolio converted to a Property Authorised Investment Fund (PAIF) in January 2013. A PAIF is a more tax-efficient fund structure that can pay out income gross of tax, which may then be taxable in the hands of the underlying investors, possibly increasing the yield.

Bestinvest also upgraded SWIP Property Trust (GB00B036Z329), which has more than three-quarters of its assets in direct property, and 8 per cent in property equities. It yields about 3 per cent and is managed by Gerry Ferguson, who has nearly 40 years' of property experience.

Mr Bamford suggests Ignis UK Property (GB00B053C307), which has delivered positive returns over the last five calendar years and offers an attractive yield of 3.75 per cent.

L&G UK Property Trust (GB00B0X5MP07) has also made positive returns over the last five years and yields 3.43 per cent.

"These score highly in our research which considers risk-adjusted returns, consistency and cost," says Mr Bamford.

Mr Moore says defensive investors could allocate up to 10 to 15 per cent of their assets to commercial property, but aggressive investors less.

Mr Bamford says investors should not allocate more than 10 per cent, due to potential liquidity problems should the market turn in the future. "As things stand, our biggest allocation to property is 8 per cent for more cautious investors, with no allocation for our highest risk investors as better prospects for risk-adjusted returns are available from equities," he adds.

Suggested direct property funds

Morningstar Property - Direct UK sector average

Source: Morninstar at at 20 January 2014, *fund providers.