The outlook for the commercial property sector in general is being understated by the market and this is providing a wealth of opportunities to the patient investor. And while the objective must always be to ensure portfolio balance relative to remit, sector exposure in strong commercial locations outside the south-east looks particularly appealing on a range of metrics.
Real estate – reading the signals
The portfolios have been overweight commercial property for some time. When first turning positive at the end of 2011, yield comparison was a key factor. This remains the case today. At a time when government bonds appear to offer little value, the sector continues to look attractive. Just as reinvested dividends account for the majority of the broader market’s total returns over time, income and rental growth similarly account for this sector’s returns.
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. Furthermore, debt levels are low and the debt that does exist has been secured very cheaply in recent years – with very few trusts having any medium-term refinancing requirements.
Add in managers’ caution and therefore lack of development exposure, their focus on income which is ensuring dividends are covered, and their diversification across sectors and regions, and the sector’s investment trusts continue to be well placed to weather any testing times. This is important to recognise. The fallout from the financial crisis a decade earlier and misplaced concerns following the EU referendum have cast a long shadow.
Indeed, few sectors have been more adversely affected by undue Brexit concern. Yet investors in particular should be wary of forecasts. The dire economic predictions from the Bank of England, the IMF and others should we vote to leave the EU, including an extra 500,000 unemployed by Christmas 2016, were so wrong the Bank had to very publicly apologise afterwards.
What we do know is that investment is about comparative advantage. Low corporation tax rates, good labour market flexibility, a skilled workforce and financial expertise are more decisive factors than World Trade Organisation (WTO) tariffs averaging 3-5 per cent should we leave the EU without a deal. We profitably trade with the majority of the world’s GDP outside the EU on WTO terms.
Witness the UK’s record levels of investment, manufacturing output and low levels of unemployment – an unemployment rate nearly half that of the EU average. Such investment decisions have been made in the full knowledge that we may be leaving the EU on WTO terms.
The commercial hubs in the regions are now fully participating in this economic good news – perhaps even more so. A weaker pound disproportionately helping their more export-orientated businesses, technology start-ups, larger companies relocating their back-office operations to where rental terms are better, and more regional-friendly government policies, are just some of the reasons. Above-inflation wage growth is also contributing.
And after decades of underinvestment and therefore shortage of supply, this demand is feeding through to sustained rental growth. Evidence suggests Glasgow saw 6.7 per cent quarterly rental growth at the end of last year – the highest in Europe. Certainly the managers of those real-estate investment trusts (REITs) focused on the regions are telling us there is no shortage of quality assets to buy. And, given this long overdue catch-up process has just started, starting yields are much higher.
Such thinking helps to explain why my company has recently been increasing exposure to the sector and regions for most of our eight real investment trust portfolios, which are covered in real time on the website www.johnbaronportfolios.co.uk. This exposure helps our Dividend Portfolio to produce a 5.8 per cent yield and our Winter Portfolio, representing the final stage of an investment journey, a 5.4 per cent yield while holding a cash level of 12 per cent.
KIDs – burn before reading
The EU’s recent core retail financial services regulations – known as Packaged Retail and Insurance-based Investment Products – have at their heart something called Key Information Documents (KIDs), which are documents which should have been produced for every single investment trust from January 2018 (and unit trusts from 2020) in order to help investors better understand what they are buying.
The central problem with these KIDs is that they can be very misleading when it comes to the assessment of risk, the projection of returns and the comparison with ‘sister’ funds. Little wonder the Association of Investment Companies (AIC), the sector’s well-respected trade body, and others have been critical, believing them to be potentially harmful to investors. The AIC’s advice regarding KIDs is that investors should "burn before reading"!
In particular, the KIDs extrapolate recent returns when detailing information about the future. So KIDs produced in a bull market will suggest higher returns, whereas those produced in a bear market will suggest lower returns. This risks encouraging the sort of investment behaviour that should be discouraged – which is buying high and selling low. KIDs could result in a ‘perfect storm’ and have the makings of a regulatory scandal.
This is an issue I have also raised directly with the Economic Secretary to the Treasury, John Glen MP, on a number of occasions over the past year. The Economic Secretary has accepted our concerns and has raised the issue with Andrew Bailey, the chief executive of the Financial Conduct Authority (FCA). Meanwhile, courtesy of pressure from the AIC and other trade bodies, the FCA launched a Call for Input consultation in July 2018.
Last week the FCA announced its findings, which agreed that the summary risk indicators and performance scenarios in KIDs can be misleading, and that the regulation could cause consumer harm. Its intention is to press the EU to think again, and this is welcome, but will take time. We also need to ensure we improve these regulations when we leave the EU. The FCA needs to act promptly. I look forward to my forthcoming meeting with Andrew Bailey.
Portfolio changes
During February, the Income portfolio added to its position in AEW UK REIT (AEWU) at a price of £0.89. AEWU seeks to capitalise on the pricing anomalies offered by smaller commercial properties on shorter occupational leases (around five years) in strong commercial locations outside the M25. Speaking recently with Laura Elkin, one of the managers, the company believes it is being overcompensated for these leases because of their duration and location. The quarterly dividend of 2p is covered and represented in total a yield of 9.0 per cent when bought.
