UK commercial property fights back

The property sector has exceeded industry expectations so far in 2017, suggesting a more robust economic environment than the experts expected. The MSCI/Investment Property Databank (IPD) monthly index has delivered total returns of 6.5 per cent, made up of 2.8 per cent of capital growth and 3.7 per cent income, for the eight months to August 2017. This compares with a total return of 2.6 per cent for the whole of 2016.

Having some exposure to commercial property could provide useful benefits for investors who are prepared to invest for at least five years. Broker Numis says that total returns from UK commercial property are expected to be 5.4 per cent a year on average from 2017 to 2021.

Patrick Connolly, certified financial planner at Chase de Vere, says: "We take a long-term view and remain positive on the prospects for commercial property over the longer term. Commercial property can provide consistent income and long-term returns and this, coupled with its diversifying nature, which provides some protection from stock market falls, means many investors should hold commercial property funds in their portfolios." He suggests an allocation of 5 to 15 per cent of your portfolio in these funds.

Certain regions and sectors are also expected to grow strongly over the next four years. Industrials – which include the huge industrial units used by online retailers to store their goods – are expected to remain the strongest sector, with estimated total returns of 7.5 per cent a year, according to Numis. Meanwhile, returns from commercial property in regional areas are also expected to perform strongly.

Colette Ord, director of investment companies research at Numis, says: "In terms of the underlying asset story in the current cycle, regional property markets are later to the recovery phase than London has been, so there’s a general feeling that capital values are still holding up there. And on the income side, there’s evidence of rental growth."

The challenging areas of the property market

However, there are also areas where the outlook for commercial property looks less rosy. Jason Hollands, managing director at Tilney Group, says his firm is neutral on commercial property partly because of worries about consumer spending power.

He says: "Despite its resilience over the past year we see the UK economy facing a softer patch as the consumer is squeezed due to higher inflation and weak wage growth. There is also an element of business fatigue, and investment decisions are stalling due to current political uncertainties."

Jason Baggaley, manager of Standard Life Investments Property Income Trust (SLI), has been trimming his exposure to retail warehousing and is underweight the retail sector.

"The sector is very difficult at the moment," he says. "There’s a lot of pressure on retailers, with higher import costs, consumers being squeezed because of inflation and less demand for shops as they move more online."

But there are some bright spots, he adds; in particular high-end retail in Central London, which has benefited from increased tourist numbers attracted by the fall in the pound.

The impact of the UK's decision to leave the EU is also likely to affect offices in Central London, according to some commentators. Offices in Central London are lagging, and expected to continue to do so, as a result of the cooling effect of the Brexit negotiations, as investors worry about large companies such as international banks moving to mainland Europe.

"Brexit could have a potentially big impact on property, but nobody knows exactly what the impact will be, as we don’t even know what [the final deal] will look like," says Adrian Lowcock, investment director at Architas. "City of London offices have not performed as well as the rest of the market and there are indications that vacancies are rising, which will have a knock-on effect on the income [funds receive]."

"London and the south-east regions are facing challenging times, particularly central London offices, which account for 20 per cent of the overall property market,” adds Mr Connolly. “Property funds may have more than 50 per cent invested in these regions. This could impact on performance in the short term."

Property trusts and funds to consider

Given the concerns about the City of London and the possible impact Brexit could have on demand for office space, Mr Hollands prefers funds with limited exposure to this market. He also prefers funds investing in properties with high-quality tenants and average lease profiles that extend well beyond the Brexit process.

One of his favourites is UK Commercial Property Trust (UKCM), which is managed by Will Fulton. The trust aims to provide a high level of income and capital growth by investing in a diversified portfolio of freehold and long leasehold UK commercial properties across the office, retail, industrial and leisure sectors.

As of June, its average lease length is 8.3 years, with only 2.2 per cent of its portfolio in City offices. The largest exposure is to industrials in the south-east, which make up 24.2 per cent of the portfolio, followed by retail warehouses which make up 21.4 per cent.

The trust yields around 4.2 per cent and as at 16 October is trading at a discount to NAV of 1.1 per cent, which is wider than its 12-month average of a premium of 0.3 per cent. Mr Hollands suggests the trust could be trading at a discount to NAV because its high exposure to the south-east makes it more regionally focused than other funds.

Another investment trust Mr Hollands rates is F&C Commercial Property Trust (FCPT), which is managed by Richard Kirby. The trust aims to give an attractive level of income, together with the potential for capital and income growth from a diversified UK commercial property portfolio investing across office, retail and industrial sectors. It has an average lease length of 7.1 years.

The trust owns 30 individual properties, with its largest holding being the St Christopher's Place Estate located near Oxford Street in London, which contains a mix of shops, boutiques, restaurants and bars. Altogether properties in the West End make up 33.9 per cent of the portfolio, but the trust only has 1.4 per cent in the rest of London.

The trust yields around 4.1 per cent and is trading on a premium to NAV of about 4.4 per cent, which is broadly similar to its 12-month average.

Numis includes Custodian Reit on its buy list of recommended trusts. This trust aims to provide an attractive level of income, together with the potential for capital growth. It seeks to identify value in the UK commercial property market by targeting sub-£10m properties outside London, where there is less price competition. The trust yields about 5.5 per cent, which is above the 4.6 per cent sector average according to Winterflood Securities' data. However it is also trading on the highest premium to NAV of its peer group, at 12.3 per cent.

Ms Ord says: "Custodian has a favourably positioned strategy and the portfolio is well placed [to perform well]. The trust has increased its dividend every year. It’s got an above-average yield and its dividend is fully covered. Although the premium is high, if you’re looking for a property trust that gives you above-average income, is very well diversified, has a good level of industrial exposure and very nicely structured debt, with lots of long leases, then that’s a good one."

Mr Lowcock likes investment trusts within the Association of Investment Companies (AIC) property specialist sector, which focus on areas such as student property, care homes and social housing, among other things. One example is GCP student living (DIGS), which targets attractive total returns and the potential for modest capital appreciation and regular, sustainable, long-term dividends with retail prices inflation (RPI)-linked income characteristics. The fund focuses on student residential accommodation assets in and around the London area. These assets are typically prime, purpose-built student properties with features such as home cinemas and rooftop gardens. Rents for these buildings are high. But there is also high demand from overseas students for prime student residential space in areas in and around London, where supply is limited.

Mr Lowcock says: "GCP is a specialist investment boutique, with particular focus on the UK social and economic infrastructure and student accommodation sector. GCP Student Living tends to offer a lower volatility property exposure with less sensitivity to the market due to its focus on student properties. It offers some inflation protection although this is not fixed."

However the trust is also trading on a high premium to NAV of 10.9 per cent. It yields 3.95 per cent, but has a high ongoing charge of 2.88 per cent.

Another trust in the AIC property specialist sector Mr Lowcock likes is Tritax Big Box Reit (BBOX), which invests in the 'big box' warehouses used by online retailers to store their goods. The trust is one of the only Reits specialising in investing in and funding the pre-let development of these facilities in the UK. And since its launch in 2013 its assets under management have increased by around 1,000 per cent from £200m to more than £2bn.

Mr Lowcock says: "This sort of asset benefits from long leases and lease renewal as the companies leasing the warehouses need consistent and reliable locations to meet their needs. Investors looking to diversify their income stream are likely to continue to find this sort of investment attractive."

Among its tenants Tritax has some exposure to the retail sector, which could leave it vulnerable in an economic downturn. But the effects of its long leases and the trend of greater online shopping, are likely to counter this. The trust yields around 4 per cent and is trading on a premium to NAV of 11.6 per cent.

Although specialist property is quite a new sector, with both GCP Student Living and Tritax Big Box launching in the past three or four years, the trusts benefit from high-quality management teams, Mr Lowcock says.

He adds: "The funds are relatively new because the opportunities are relatively new. Big box warehousing has come about as a direct result of the rise in internet shopping and companies such as Amazon needing big warehouse space for that. While the growth in student living has happened as a result of the change in student fees which was increased demand for better living spaces."

Mr Connolly prefers to get his exposure to commercial property via open-ended direct property funds such as M&G Property Portfolio (GB00B89X8P64) managed by Fiona Rowley. This fund aims to provide income and grow capital over five years or more by investing at least 70 per cent of the portfolio directly in UK commercial property. It yields 2.85 per cent.

As of August the fund was invested across 110 properties and had its highest exposure to offices at 30.6 per cent, followed by retail warehouses at 21 per cent and the industrial sector at 16.7 per cent. The largest regional exposure was to the south-east at 41.4 per cent, followed by the Midlands at 19.1 per cent, with Central London representing only 3.4 per cent of the fund. Cash and near cash makes up 19.4 per cent of its portfolio.

Mr Connolly also uses Legal & General UK Property Fund (GB00BK35DT11) in client portfolios. This fund is run by Michael Barrie and Matt Jarvis. It aims to provide a combination of income and growth and will typically invest at least 80 per cent in a range of UK commercial properties. However, this can be as low as 60 per cent where the manager deems it to be in the interests of the fund and its shareholders. The fund has 68.26 per cent invested in direct property, with 24.57 per cent in cash. It yields about 2.19 per cent.  

The fund's highest sector exposure is to industrials, which make up 21.51 per cent, followed by offices in regional areas which total 14.37 per cent. Altogether it has 7.99 per cent in London offices. Its largest regional exposure is to the West Midlands at 13.86 per cent, followed by the south-east at 10.60 per cent.

Henderson UK Property PAIF (GB00BP46GG64), managed by Marcus Langlands-Pearse and Ainslie McLennan, is another ‘bricks and mortar’ fund Mr Connolly uses. The fund aims to achieve a high income together with some growth of both income and capital through investment primarily in commercial property and property-related assets. It yields 2.92 per cent.

Retail makes up the largest sector in the fund, representing 30.8 per cent of the portfolio, followed by offices at 17.9 per cent and industrial at 17.3 per cent. The fund is holding 16.9 per cent in cash.

Property trusts and funds performance

Source: Morningstar as at 13 October 2017  *The AIC (includes performance fees)