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Making the case for commercial property

John Baron highlights the sector’s attractions and those investment trusts set to benefit from the expected outperformance
December 5, 2019

Last month’s column explained why UK smaller companies looked particularly attractive at this point in time and pointed to those investment trusts set to benefit as sentiment catches up with fundamentals. This column also stays with the UK and suggests investors are neglecting another sector at their cost – that of commercial property. It explains why the market is unduly concerned about the sector, some of the strategies we at Equi are pursuing to capture the best returns, and those investment trusts we favour to benefit most from the expected change in sentiment.

 

The consensus challenged

There can be little doubt the sector was hit hard during the financial crisis a decade ago, particularly those companies with significant borrowings, interest costs and development exposure. The market was ruthless and significant share price falls were seen. It took some years before confidence started to return. However, most sector investment trusts are more resilient today than they were then.

Debt levels are low and the debt that does exist has been secured very cheaply in recent years – with very few companies 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 generally covered, and their diversification across sectors and regions, and the sector’s companies continue to be well placed to weather any testing times.

Furthermore, a noticeable feature of this property cycle has been the lack of investment and therefore shortage of supply. When combined with an improving economy, high cost of moving location and good asset management, this is tending to feed through to rental growth and some capital appreciation. Of course, certain strategies and locations will do better than others – as ever, stock selection is key.

But Brexit has also cast a long shadow – the closure of a number of commercial property open-ended funds immediately after the referendum result remains a point of discussion for investors and focus for the Financial Conduct Authority (FCA). The reasons as to why these concerns are overdone were covered in last month’s column, to which new readers to this column may wish to refer.

What can sometimes be underestimated is that investment is about comparative advantage. Low corporation tax rates, good labour market flexibility, a skilled workforce, world-class universities and financial expertise are, in aggregate, more important than World Trade Organisation (WTO) tariffs averaging 3-5 per cent should we leave the EU without a deal. Witness the UK’s good levels of investment, high manufacturing output, and low levels of unemployment. The irony is that Boris Johnson’s deal makes a trade deal more likely.

 

Further positives

There are further reasons to be positive about the sector – despite the gloom. When I first turned positive on the sector 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 while offering the prospect of income growth.

Chart 1 helps to put this into context. It looks back over 20 years and compares the yield achieved on 10-year gilts with that of UK prime property. It suggests that, while there was usually a sector yield premium (apart from 2006-07), the premium is now broadly at a historical high. As gilt prices have risen (and yields fallen), the yield on commercial property has fallen far less – perhaps helped by a modicum of rental growth over the period.

It is true that gilt prices do not look particularly attractive at present, but they would have to retreat by some measure if the sector’s yield premium was to be eroded in any meaningful way. The outlook for global economic growth and interest rates suggest this will not happen soon. Meanwhile, there is evidence that, courtesy of limited development and therefore supply, rental growth is picking up.

If one was uncharitable, it could be suggested that I am are being a little selective in my comparison, and that I should widen the scope by comparing the sector’s yield with other asset classes, including equities and corporate bonds. Chart 2 attempts to do this by also including the yields offered by the FTSE 250 index (grey line) and corporate bonds (green) at both ends of the risk spectrum.

For completeness, it also shows the commercial property yield by comparing the IPD (the sector’s benchmark) on both an initial (blue) and equivalent (dotted blue) yield basis. The initial yield is the yield based on the rent today, whereas the equivalent yield is in effect the time-weighted average yield of the future expected income (taking into account the expected reversion in the income stream). The picture painted is broadly the same – the sector’s yield premium remains very much intact.

Furthermore, within this discussion, we should remember the importance of income (which factors in rental growth) to total returns over time. Just as reinvested dividends account for the majority of the equity market’s total returns, income similarly accounts for the sector’s returns. Small numbers assume increasing importance over time.

Again, to help put this into perspective, chart 3 reports on annualised IPD return figures, since its inception 19 years ago, across various UK regions. It quite powerfully shows that, in each case, income makes up the highest proportion of total return – accounting for over three-quarters of total return for the sector generally.

Sector strategies

But as with any sector, nuances exist and stock selection remains as important as ever. I believe certain sub-sectors, such as retail, should continue to be avoided despite the temptation to believe a lot of the bad news is in the price. The ramifications of the internet still have some way to play out, particularly as the larger technology companies eye further opportunities.

Little wonder retail assets are suffering from oversupply and lack of occupier demand in many locations. According to recent research, 37 retailers have gone into administration so far this year – affecting nearly 1,663 stores. Failures include Debenhams, Select Fashion, Pretty Green, Patisserie Valerie, Office Outlet, The Money Shop, LK Bennett and Thomas Cook.

By contrast, I continue to favour good quality offices and industrial sites/assets. Given the outlook for the economy and extent of inward investment, both of which have remained robust despite the perceived uncertainty of Brexit and talk of no deal, the outlook remains favourable. The positive case is reinforced if one considers the potential for rental growth given the lack of development and therefore supply.

Within that broad canvas, I also believe the best returns will come from the regions, given the extent to which the south-east has outperformed in capital terms in recent years. 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 – particularly when experienced managements can add value courtesy of good asset management.

Indeed, chart 3 highlights the London mix of income and capital returns with that of other major cities. The regions have a lot of catching up to do given how far they have fallen behind, and this is something the corporate sector is increasingly recognising when looking to locate businesses or to reduce costs by relocating.

The commercial hubs in the regions are now more fully participating as the economy moves forward – and offices and industrial assets are in the vanguard. A weaker pound disproportionately helping their more export-orientated businesses, the growth in 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.

Indeed, chart 4 highlights research from CBRE which indicates that regional offices have outperformed in comparison to central London offices for the past three years – delivering superior returns of 10.4 per cent in 2019 (year to date) in comparison to central London office returns of 5.3 per cent.

Other research suggests strong occupational demand has come from the IT sector, while a limited development pipeline will most likely continue to put a downward pressure on supply and vacancy rates. After decades of underinvestment and therefore shortage of supply, little wonder this demand is feeding through to sustained rental growth.

Meanwhile, led by the East Midlands, take-up of industrial units remains robust. This was driven by the largest deal so far this year, namely Jaguar Land Rover’s move into a new 3m square foot global parts distribution hub. Increased competition and dearth of supply of good-quality units is again leading to increased rents.

Various forecasts suggest rental growth in the industrial sector of up to 3.0 per cent in 2019. Further forecasts predict around 2.0 per cent and 1.7 per cent average rental growth respectively for the next few years. By comparison, the IPF UK Consensus Forecast predicts that the All Property average annual rental value growth expected for 2019 is -0.2 per cent.

Of course, there will be variations between the regions. Evidence suggests Glasgow saw general sector quarterly rental growth of 6.7 per cent at the end of last year – the highest in Europe. Certainly the managers of those real estate investment trust (Reits) focused on the regions are telling us there is no shortage of quality assets to buy. And, given this overdue catch-up process has just started, starting yields are much higher.

 

Favoured holdings

The holdings favoured by my portfolios to capture these themes are Standard Life Property Income (SLI), Regional REIT (RGL) and AEW UK REIT (AEWU) – each being run by long-serving and respected managements who believe the sector outlook remains positive. At time of writing, all companies are standing on modest discounts, have covered dividends and are offering yields of 5.4 per cent, 7.6 per cent and 8.6 per cent, respectively. Chart 5 highlights their sound performance in recent years relative to peers.

SLI has a balanced geographical exposure, which is focused on industrial assets, with office being the next largest sub-sector – retail/other being less than 10 per cent of net asset value (NAV). In a recent comment, Jason Baggeley (lead manager) said: “SLI is focused on providing an attractive level of income to investors. Its high exposure to the industrial sector, and very low exposure to the retail sector, mean it is well positioned to continue to outperform the UK real estate market, and deliver a predictable level of income to investors through its diversified portfolio.”

RGL’s primary focus is on offices (78 per cent of NAV) and industrial sites (14 per cent) in the regional centres outside the M25 motorway. Stephen Inglis, chief executive of London & Scottish Property Investment Management, portfolio manager for RGL, commented: "The company has continued to achieve considerable success resulting in another period of positive momentum throughout 2019. During the first three quarters, we executed significant positive re-letting activities and completed a number of attractive acquisitions to increase further the scale and diversified income of our portfolio."

Meanwhile, AEWU is focused on delivering enhanced returns from the smaller end (up to £15m) of the commercial property market. The company believes there are pricing inefficiencies in smaller properties, resulting in a significant yield advantage. Nearly 50 per cent of the portfolio is invested in industrial assets, with over 20 per cent invested in offices. I believe the modestly shorter leases allow greater potential for rental growth and capital uplift through prudent asset management as the economy continues to make progress.

As Laura Elkin, portfolio manager, put it to me: “With the portfolio’s very light exposure to retail and its overweighting to low rented, regional industrial, it is well placed to continue to provide attractive income over coming quarters. As a manager, our stock selection expertise lies in identifying assets in locations with strong tenant demand and limited competing supply. This is particularly accretive when combined with our active asset management approach and AEWU’s shorter income profile. The business plans for a number of AEWU’s assets are reaching maturity, providing potential to add capital value over the coming months.”

The portfolios also have lesser exposure to Schroder European Real Estate (SERE), which specialises in ‘European growth cities and regions’, and TR Property (TRY), which invests primarily in pan-European property equities – and therefore is more directly correlated to the markets.

All offer attractive returns to the patient investor.