The past five years or so have been decidedly mixed for commercial property investors. On the one hand, Brexit, the pandemic and the rise in flexible working have upset demand patterns for office space and high-street shops. On the other, investors focused on industrial, logistics and warehouse assets – which facilitate online deliveries – have seen handsome returns.
- Income growth potential
- Prudently managed
- Lower fees than peers
- Lower yield than peers
- Discount has narrowed
- Economic sensitivity
This has resulted in a “two-tier market” for real estate investment trusts (Reits), according to AJ Bell's head of investment analysis, Laith Khalaf. While logistics Reits trade at lofty premiums to their net asset values, retail and office landlords now sit at wide discounts. However, for a certain category of fund – owners of unloved real estate pivoting towards more so-called 'new economy' assets – there are much less demanding valuations to be found. As well as offering a decent prospect of income and asset growth, these funds also offer some inflation protection along the way.
UK Commercial Property Reit (UKCM), one of the largest and oldest funds of its kind with assets of £1.57bn, looks like an attractive and conservatively managed option. Set up in 2006, it is managed by abrdn's (ABDN) Will Fulton, who recently returned to the helm following a brief spell on medical leave. For the past few years, he has been refocusing the portfolio on sectors “supported by the long-term structural drivers of the modern economy, including the continued rise of e-commerce and urbanisation”.
This has involved the sale of two retail parks and two office blocks in the past couple of years, and the acquisition of a handful of industrial assets, some of which are under development. Some 63.4 per cent of the portfolio is now invested in industrial assets, where demand has been outstripping supply, and just 3 per cent is invested in standard retail.
The quality of assets and tenants is crucial for the reliability of income for Reits. While UKCM’s yield is low compared with rivals at 2.8 per cent, its tenant void rate of just 2.1 per cent at the end of December suggests the trust has little difficulty in finding and retaining tenants. Rent collections proved pretty robust over the pandemic, dipping to 83 per cent in 2020 but jumping back to 97 per cent last year, in line with 2019.
While the trust is large, it only has around 40 properties, meaning the average lot size is just under £40mn. “These are typically very large and good quality assets reflected in the low net initial yield of the portfolio,” says Dan Cartridge, assistant fund manager at Hawksmoor Investment Management.
The trust also has a diversified tenant mix of around 200. The largest individual occupier is Ocado (OCDO), which makes up 5.1 per cent of its rent, followed by Warner Bros (US:WBD) at 4.6 per cent and Amazon (US:AMZN) at 4.4 per cent. A further 5 per cent of space is leased to the public sector. On balance, Ocado looks the riskiest of these tenants, although Thomas McMahon, senior investment trust analyst at Kepler Trust Intelligence, notes that logistics assets are in high demand. Any lost tenancies in these assets, should they occur, should be fairly straightforward to fill.
As well as downside protection, UKCM has thought about expansion, too. The trust has bought a handful of assets in the past six months that have “substantial growth potential”, according to QuotedData property analyst Richard Williams. This included £94mn on a life sciences business park in Leamington Spa that is dedicated to being one of two UK ‘Megalabs’ aimed at increasing Covid-19 testing capacity in the UK and developing the UK’s diagnostic capabilities more broadly for other critical illnesses. Precision Park also has 3.7 acres of development land where the managers plan to build an industrial asset.
As industrial assets have become more richly valued, buying assets with development potential can add value – if all goes to plan.
Potential for income growth
Some of the trust’s recent purchases will start to repay their investments soon. Land bought in Edinburgh in 2020 for the building of new student accommodation is expected to be in service for the coming academic year. The trust also bought three warehouse units near Gatwick last December, which are under construction, but expected to start life at an attractive development yield of 5.8 per cent a year. That compares favourably with tenanted industrial assets in the investment market, where yields below 4 per cent are common.
While it is up to the board to determine the dividend, these assets hint at good near-term distribution growth.
Impressive performance last year underpinned a 16 per cent increase in the latest quarterly dividend. While a worsening economic outlook could hinder tenants’ ability to absorb rent rises in 2022, Williams points to rental growth forecasts in the warehouse sector of around 7 per cent for the UK this year, and “more like 20 per cent” in prime locations such as London. Little wonder then, that the board believes the 0.75p-a-share quarterly distribution is both “sustainable” and capable of growth as existing capital is deployed and portfolio developments are completed.
In terms of lease-based inflation protection, only 26 per cent of rental income is index-linked or on fixed uplifts. But this is not a bad thing given the high exposure to industrials where it is – and indeed has been – better to be exposed to open-market rent reviews, which have been rising well ahead of inflation in recent years.
Mick Gilligan, head of managed portfolio services at Killik and Co, also notes that UKCM’s reversionary yield (yield if all properties were re-let at current market rates) was estimated at 8.7 per cent in the fourth quarter of 2021. “This is comfortably above the current Epra earnings yield of around 4 per cent,” says Giligan. “So, with around 20 per cent of leases expiring in the next three years, there should be good scope to raise rents and help keep income ahead of inflation.”
The trust has one of the sector’s lowest loan-to-value ratios (also known as gearing), which has led it to lagging peers in rising markets. However, lower relative borrowing levels served it well when markets fell at the start of the coronavirus pandemic in 2020. More recently, the managers have been drawing on the portfolio’s debt facility and its debt level was 13.5 per cent at the end of last year. This is still comparatively low for a sector in which peers’ portfolio gearing routinely sits between 20 and 40 per cent, and might give investors some comfort given the precarious economic outlook.
“I think they have deployed capital well in recent times and I like the conservative approach to leverage,” says Gilligan. “I think UKCM’s ultra-low gearing is a key differentiator in a sector that [saw] high gearing trip up a few Reits during the financial crisis.”
However, it’s not for everyone. Cartridge says: “While we like management teams to take a cautious approach to deploying gearing, there is probably an argument here that gearing could be modestly increased to help improve dividend cover and for efficient capital management.” Interest rates are, after all, still fairly low in historical terms.
Value and risks
In the early days of the pandemic, the trust traded at a more than 20 per cent discount to the value of its assets. It has tightened considerably and is now around 9 per cent, which to Williams “still seems too wide given the quality of its portfolio”.
However, the macroeconomic outlook is unnerving for property investors. If inflation persists over 6 per cent for a protracted period, bond yields will rise and the relative attractiveness of the trust’s low yield will diminish. Rising rates will also squeeze some tenants' margins. “If this is happening while general costs are rising too then it presents a big headwind to real estate assets and other risk assets,” says Gilligan.
Given the fund’s low gearing and borrowing profile – its loans have over six years to maturity on average – sharply rising interest rates should not be as costly for the trust as its peers. “High interest rates are generally bad for the real estate sector, but we are still in an extremely low interest rate environment, historically, at 0.75 per cent,” says Williams. “It wouldn’t be until rates hit 3 per cent that property investment yields start to look sharp, and a price correction becomes inevitable. We are some way off that.”
The trust is unlikely to deliver knockout results, but for an investor looking for income and growth potential, UKCM is an interesting option. Its board seems to think so too – with three of the directors topping up their holdings so far in 2022.
|Fund name and ISIN||UK Commercial Property Reit (UKCM)|
|AIC sector||UK Commercial Property||NAV||102p|
|Fund type||Investment trust||Price discount to NAV||-9.3%|
|Market cap||£1.20bn||Ongoing charge*||1.51%|
Source: Winterflood 14.04.2022. *AIC. **Abrdn. More details: www.ukcpreit.com
|Fund/benchmark (%)||1 year total return||3 year cumulative total return||5 year cumulative total return|
|UK Commercial Property Price||27||16||24|
|UK Commercial Property NAV||20||20||39|
|Source: Winterflood 14 Apr 2022|
|Top 10 holdings||Value band|
|Ventura Park, Radlett||Over £100mn|
|Science in Sport||Over £100mn|
|Allergy Therapeutics||Over £100mn|
|Keystone Law Group||£70-£100mn|
|Emerald Park East||£50-£70mn|
|Junction 27 Retail Park||£50-£70mn|
|The White Building||£30-£50mn|
|Source: UKCM factsheet, 31 Dec 2021|
|Sector breakdown (%)|
|Industrials - South East||6.2|
|Industrials - rest of UK||5.8|
|Other (incl leisure)||13.4|
|Offices - rest of UK||12.8|
|Offices - rest of South East||14.0|
|Offices - West End||17.1|
|Standard retails - rest of UK||5.0|
|Standard retails - South East||0.0|
|Source: UKCM factsheet, 31 Dec 2021|