After enjoying a robust and prolonged post-crisis rebound, property funds appear to be once again on shaky ground with the asset class recently suffering its worst quarterly outflows in seven years. Growing concerns over the imminent referendum on the UK’s European Union membership coupled with slowing economic growth, to which commercial property is intrinsically linked, are taking their toll.
Notably, while official numbers show UK economic growth eased to 0.4 per cent during the first quarter, down from 0.6 per cent in the previous three months, during the period construction output fell 1.0 per cent quarter-on-quarter and was down 1.8 per cent year-on-year.
The volume of UK commercial property investment transactions has been conspicuously suppressed too. Henderson UK Property fund director Andrew Friend highlights that investment levels for the asset class came in at some £9.1bn for the first quarter of 2016, which represents approximately half the levels at the same point in 2015.
He says: “While these lower levels could be partly a result of concerns over Brexit, the volatility and uncertainty within financial markets generally is likely to have played a larger part.”
Of course, 2016 has hardly been covered in glory for risk assets in general, given the year got off to one of the worst starts in living memory where at one point the FSTE 100 crashed by some 11 per cent in the space of just over a month, causing many investors to flee equity markets.
But during the first quarter of 2016, property funds endured three straight months of outflows to the collective tune of £166m according to numbers from the Investment Association. During February alone the asset class suffered a drain of £119m, its largest since November 2008.
The last time investors witnessed a quarter with negative net retail flows for property funds was during the height of the financial crisis in the first three months of 2009, when a notably lower £84m flowed out.
“The danger is that investors start to panic, not wanting to be the last one through the door and risk being left in a gated fund”
In all it marks a dramatic fall in popularity, given that last year the category was among the best sellers, while in 2014 it enjoyed its best-ever annual sales, at £3.8bn.
Property is no stranger to controversy. In the years running up to 2007, investors had got used to very strong returns but when the crunch hit property values nosedived and, between June 2007 and July 2009, UK commercial property values plummeted by 44 per cent, according to the IPD UK Monthly index – the steepest fall it has ever registered. Panic ensued as investors attempted to pull their cash out but the illiquid nature of bricks and mortar meant many funds had to impose lock-in periods.
In recent years the prolonged backdrop of ultra-low interest rates has boosted the attraction of the asset class and in many cases it has acted as bond proxy for investors – after all yields of circa 5 per cent have been commonplace on direct property funds. In addition commercial properties have enjoyed very strong capital growth too, especially in London and the South East. A recent report from New London Architecture shows there are a hefty 436 tall buildings – those of 20 floors and more – in the pipeline for the capital.
What are the returns?
Exposure to the asset class has been very rewarding. Over the past seven years to 25 May, data from FE shows that the IA’s Property fund sector, which houses property equity vehicles as well as direct portfolios, has delivered an average total return of 86 per cent and 34 per cent over five years.
However, it seems the easy money has been made and investors hoping for annual double-digit returns are likely to be disappointed, as the general consensus seems reasonably confident that capital appreciation going forward is not likely to keep up with the past couple of years.
BMO Global Asset Management co-head of multi-manager Gary Potter says: “Property has enjoyed strong capital appreciation and, while yields currently look robust, I do not think investors should expect much in the way of capital uplift from now on.”
Post-crisis, managers have been keen to maintain flexibility in their funds holding relatively high cash balances, with many teams keeping approximately 20 per cent in liquidity. But while the flood of money coming into the sector over recent years has also provided managers with a decent buffer to take care of any withdrawals, the recent reversal of this trend has sparked concerns that the market could see further outflows.
The issue has been starkly highlighted by the recent decision of Standard Life Investments, Henderson Global Investors, M&G Investments and Columbia Threadneedle to alter the pricing structure of their commercial property vehicles in order to protect long-term investors. The changes meant that investors selling out got less than they would have beforehand.
However, the move has been broadly welcomed. Square Mile head of research Victoria Hasler believes the decision probably says “far more about the technicalities of property funds than the market itself” and that it is the “fair way to treat existing and long-term investors”.
She adds: “Of course the danger is that investors follow a herd mentality and start to panic, not wanting to be the last one through the door and risk being left in a gated fund. I think that is unlikely to happen in the near future though, if only because there is a lack, particularly on the income side, of attractive alternative investments.”
Whitechurch Securities managing director Gavin Haynes also believes it has been prudent for managers to move pricing and overall he remains relatively upbeat in his outlook. He says: “Although the negative sentiment is causing a short-term drop in appetite for these funds I believe there is value in the asset class. “We continue to monitor the funds and the yields available versus alternative income asset classes. Although we have reduced exposure this year we will continue to have exposure to a basket of funds within multi-asset portfolios.”
Hasler points out that most managers seem to expect returns to be mid-single digit for the next few years, and this will be driven largely by income rather than capital.
However not everyone is as optimistic. Hargreaves Lansdown has not had a property fund on its recommend list since 2013. Senior analyst Laith Khalaf says: “Property funds themselves are expensive because of the high costs associated with purchasing and maintaining a property, which explains why the sector has fallen so far short of the commercial property index.
“The liquidity issue also poses a problem for open-ended funds. We do not have any property funds on the Wealth 150 right now and have no plans to add any. It is just not a particularly effective way for investors to allocate capital.”
Morningstar’s discretionary managed service has also exited its exposure to property in its active managed funds available in the UK. The group’s Managed Portfolios, co-manager Simon Molica says: “After a strong recovery in commercial property valuations over the past three years, we now expect lower total returns from the asset class in the future. I think there are some great risks out there with property, and liquidity is one of the real risks that people need to be aware of. There has been a strong recovery, but you have got to question what the risks will be. So actually in this asset class we like to be quite cautious, and we like to exit quite early – in fact, as early as possible.”
HSBC Open Global Property fund manager Guy Morrell, who invests across both unlisted and listed property funds, says that his view of the prospective returns for UK direct property has reduced significantly as prices have risen. He says: “Three years ago, initial yields stood at 6.3 per cent, according to the IPD UK Monthly Index. The latest, at March 2016, yield had fallen to just below 5 per cent. The market has become more keenly priced.
“At the end of 2014, UK direct property funds accounted for around 45 per cent of our fund, whereas today they account for just under 30 per cent,” he adds.
Kames Property Income fund co-manager Alex Walker also anticipates that returns “are likely to be more modest looking forward” but he still expects to see a healthy performance that will remain attractive to investors.
“There has been a strong recovery, but you have got to question what the risks will be. So actually in this asset class we like to be quite cautious, and we like to exit quite early”
He says: “The property total return profile is likely to be dominated by the income element from this point, marking a return to the more traditional property return model. We do, however, believe there is scope for capital value increases through continued rental growth and the successful completion of asset management initiatives. We believe secondary property continues to offer an attractive but selective buying opportunity, as the current yield gap relative to prime real estate remains attractively wide.”
While the ‘Brexit’ factor is undoubtedly putting a strain on the sector, if it doesn’t come to pass, the general consensus is that commercial property will steady as the asset class moves towards offering a regular but relatively attractive medium-term performance as it transitions to more income-led returns.
A vote to leave, however, is likely to throw up a very different scenario. Henderson’s Friend asserts that this would create a degree of re-pricing risk in the market.
He says: “The extent and longevity of this would depend on how markets digest the process of the subsequent negotiations. The number of well-capitalised domestic and overseas buyers of UK commercial property should provide a ceiling to any valuation adjustment, and commercial property would not be alone in facing uncertainty as equity and bond markets also digest a Brexit outcome.”
However, a “disorderly Brexit” would have the most marked negative business impact, according to Friend. “Changes to the free movement of labour and a preference of firms to locate within, rather than outside, the EU could hurt the UK’s competitiveness and productivity,” he says. “A fall in investment and hiring would hurt growth and occupier demand, and the UK’s – and principally London’s – financial role in Europe would also come under scrutiny, leading to downward pressure on office valuations in the capital.”
Do fundamentals remain sound?
Looking at the state of play, FE head of research Rob Gleeson believes the market volatility may create opportunities for investors who can weather the short-term disruptions. He says: “In the UK, portfolios holding fewer City offices should emerge in a better shape than less diversified ones. Elsewhere, low interest rates may make real estate an appealing proposition. Rental growth is helped by improving economic conditions, which would see corporates increasing their demand for space.”
But while the commercial property market can be affected by short-term negative sentiment from events such as Brexit, M&G Property Portfolio manager Fiona Rowley believes the sector is entering a maturing phase of the cycle. She expects “more normal mid-single digit returns, dominated by income rather than capital growth”. Ultimately, however, Rowley feels that the underlying fundamentals of property remain sound. She notes even before the referendum took centre stage there were already signs of a slowdown in central London but she sees potential for strong rental growth in regional offices. Rowley highlights that major cities such as Manchester and Birmingham are attracting growing interest from occupiers.
Longer term, over the next three years, Rowley is forecasting UK commercial property returns of 6 per cent per annum, most of which will come from income.
She says: “At the property level, buoyant tenant demand and insufficient supply are combining to create rental growth across the regions, helping to compensate for the deceleration of capital growth by yield compression.”
What are fund pickers backing?
While advisers and fund pickers might well have trimmed some positions, many are still happy to back property funds. Axa Wealth head of investing Adrian Lowcock says: “Given that the outlook for UK interest rate rises has been pushed back to 2019 for some forecasts – although this might reduce after the EU referendum vote – either way the view is rates will be lower for longer. This is supportive of the asset class. There is a lack of supply for property and the yields on offer are attractive relative to equities and bonds.”
For his part he backs the £2.6bn Legal & General Property Growth fund, which is up by 41 per cent over five years to 25 May and yields circa 3.5 per cent. He says: “This is a suitable core offering for investors. The fund is managed by Matt Jarvis who considers both the wider economic picture as well as individual investment analysis.”
Chase de Vere certified financial planner Patrick Connolly says he usually holds between 8 per cent and 15 per cent of client portfolios in commercial property. While he expects that overall returns are likely to be lower than in recent years, his firm will continue to hold the asset class. “We only use property funds that invest predominantly in actual ‘bricks and mortar’ property, which have experienced management teams, consistent performance records and diversified portfolios, where they invest in a wide range of different underlying properties,” he says.
Among his recommendations is the £4bn Henderson UK Property portfolio. The vehicle’s team seeks out properties that are of good quality, well located and properly managed. Over five years, it is up 36 per cent and boasts a yield of some 3.1 per cent.
Haynes rates the £4.6bn M&G Property Portfolio, which like many of its peers is diversified across a number of different sectors, such as retail, offices and industrial buildings. Over five years, the fund is up by 31 per cent and yields approximately 3.9 per cent. He says: “The recent price drop provides an opportunity for the long-term investor to buy in.”
Square Mile’s Hasler also backs the portfolio, adding: “The team has a disciplined and proven investment approach and is extremely aware of the importance of income, liquidity and the main drivers of the property market.”
The obstacles engulfing property have not bypassed investment trusts’ focus on the sector. While those in favour of this approach obviously argue that the closed-ended, listed nature of investment trusts tends to suit the asset class given its highly illiquid nature, there has still been a change in sentiment. As at 25 May, the Association of Investment Companies’ Property Direct UK sector was carrying an average discount of 2.9 per cent, which is a far cry from recent years, where it has at times soared to double-digit premium territory. But again performance has been respectable, with the typical fund up 35 per cent over the past five years.
Surveying the backdrop Rathbones senior collectives analyst Mona Shah says: “There have been some de-ratings from historically stubborn premiums to discounts, and perhaps some of the steam needed to be taken out of the sector.”
However, despite the outlook for capital growth being more muted, Shah believes some of these discounts now look interesting, based on rental growth.
She adds: “We are nervous about some of the vehicles moving into lower quality, or secondary sites to capture the demand for yield. Their closer correlation with equities potentially offsets their diversification benefits. Our outlook for UK commercial property is that rental growth is the biggest contributor to future total returns, rather than recent capital gains, driven by demand/supply dynamics.”
On this basis Shah prefers managers with a quality bias. Among her key picks within the UK Property Direct sector, she highlights the UK Commercial Property Trust and F&C Commercial Property Trust, which are on respective discounts of 3.1 per cent and 5.1 per cent.
Within the closed-end space, Haynes rates TR Property, a property securities portfolio, as “a good core holding”. The fund is managed by Marcus Phayre-Mudge, and is trading on a discount of 9.2 per cent.
For intrepid investors looking for a specialist play, Miton Global Opportunities fund manager Nick Greenwood highlights Phoenix Spree Deutschland, which aims to deliver income and capital growth through investment in German real estate, with a focus on residential properties in Berlin and secondary German cities. The trust remains popular, however, given it is on a premium of 7.2 per cent.
Potter also prefers a specialist approach, and highlights GCP Student Living, which specialises in student accommodation and is trading on a premium of 1.1 per cent. “There is an enormous uplift on these properties being sold into the market, which are moving from the rental to private sector,” he says.
Managers specialising in property shares are also positive. Fidelity Global Property fund manager Dirk Philippa says the UK, with the exception of some sectors, is a “buy”. Earlier this year he upped his UK underweight to an overweight position. He says: “There have been some great discounts due mainly to the Brexit risk and I was able to get more shares for my money than I could six months ago.”
HSBC’s Morrell adds that finding value in an environment of falling yields is challenging. As such he has a general preference for listed over direct property, partly on valuation grounds and partly for liquidity reasons.
He says: “We see long term value in certain property segments of the US and Asia Pacific, particularly where the market is trading at wide discounts to underlying net
Schroders co-head of global real estate securities Tom Walker says that one area it banks on is a growing list of cities that are moving away from their home countries.
“We believe that there are certain cities around the world, and we refer to these as global cities, such as Los Angeles, New York and London, that are detaching away from the countries and regions they are in,” he says. “These very powerful global cities will continue to perform very well by virtue of high quality infrastructure, very diversified economies and talented workforces.”