Is the party over for property?

Commercial real estate deals are at a six-year high and the economic outlook appears to bode well for the asset class. But some experts say that property is not as popular as it seems and that as rental growth becomes the dominant driver it will revert to being a dull diversification pick, writes Philip Scott

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As rebounds go, property funds have been the comeback kid of 2014. After a caustic period for bricks and mortar during the financial crisis, which left many an investor nursing heavy losses, it seems that past troubles have been forgiven, if perhaps not forgotten.

Since the start of 2014 property has been one of the best-selling fund types. According to the Investment Management Association, property funds have notched up more than £2.9bn in net retail sales – almost double the £1.5bn achieved in 2013, which itself was significantly up on the previous 12 months.

Property’s popularity is echoed on the closed-ended side, where a flurry of investment trusts, including Schroder Real Estate and F&C UK Real Estate Investments, have issued new shares to satisfy demand.

Many portfolios have become pricier, too. For example, the average fund in the Association of Investment Companies’ Property Direct: Europe and Property Direct: UK sectors is typically trading on a premium.

The turnaround in investor sentiment has been driven by several factors. These include rising occupier demand, better credit conditions and more attractive valuations, all of which have contributed to better returns and attractive yield prospects.

Certainly, given the turmoil engulfing fixed income markets and nigh on zero interest available from cash deposits, commercial property has been acting in many cases as a bond proxy. But the overall improvement in the economic environment, an element that the fortunes of this asset class are naturally closely attuned to, has been the fundamental driver of its return to prominence.

Commercial property transactions have bounced back to a six-year high and in London alone, plans for an impressive 230 major buildings are in the pipeline, according to New London Architecture, the centre for the built environment in the capital.

The economic outlook also appears to favour property, as the general consensus is that the UK’s GDP will increase by about 3 per cent this year, which would be Britain’s best growth rate for some seven years.

The downfall
Rewind to 2006 and property funds were at the height of their popularity. Such was their attraction that during those 12-months investors ploughed £3.6bn into the IMA sector. Commercial property investors had become accustomed to high performance as capital values rocketed in the years running up to the financial crisis. But when the dark days of 2007 arrived, fortunes turned rapidly and performance crashed.

Between June 2007 and July 2009, UK commercial property values plummeted by 44 per cent, according to the IPD UK Monthly index, the steepest decline the index has ever registered. Panicked investors tried to cash in their holdings but the illiquid nature of bricks and mortar meant that many fund management groups at the time had to impose lock-in periods to stave off a Northern Rock-style run on assets.

The market today
Surveying the UK market today, HSBC Open Global Property fund manager Guy Morrell reckons the UK has been in something of a sweet spot.

He says: “The economy is improving, new development is generally under control, and rental values are edging up, albeit modestly. According to the IPD UK Monthly Index, All Property Rental values grew by about 2.5 per cent over the 12 months to September 2014, the fastest annual growth since the middle of 2008.”

In terms of performance, over the 12 months to 10 November the average IMA-listed property fund has beaten shares with a total return of 9 per cent, over which time the FTSE All-Share index has edged up by just 2 per cent. Over the past five years, while the FTSE All-Share is up 57 per cent the typical commercial property fund is up by a still robust 44 per cent.

One of the primary drivers of performance across the sector has been the downward movement in yields as prices have been driven up. The yield on offer has been a major attraction for income-starved investors, but as capital appreciation has stagnated, that income has been squeezed.

Some 12 months ago, yields of plus 4 per cent were more common than they are today. In fact, the yield impact contributed 11.4 percentage points to capital performance of the IPD UK Monthly Index over the 12 months to 30 September, which saw a total return of 19.7 per cent over the period.

However, the downward movement in yields has led Morrell to reduce his long-term return expectations for the UK compared with a year ago. “Nonetheless, we believe the market is priced to deliver reasonable prospective returns over the long run, with strongest performance expected in the short term,” he adds.

Seven Investment Management investment manager Camilla Ritchie asserts that reports from the property funds now suggest that yields have stabilised across almost all areas of the UK commercial property market, particularly among prime properties. However, while the strong contraction in yields seems to be coming to an end there remains scope for growth from some sectors of the market.

Darius McDermott, managing director of Chelsea Financial Services, is not surprised at the resurgence in property’s popularity, given that “the returns have been good”. However, he cautions that the commercial property rebound is “a story that is well under way”.

He says: “I think the next 12 to 18 months will be good, after which it might be a little bit more dull and move into a much more income-driven return.”
Aviva Investors Property Trust manager Philip Nell broadly agrees. He expects the market to continue delivering strong returns in the near term before “moderating over the medium-to-longer term”.

Henderson UK Property fund manager Ainslie McLennan also says that while capital growth has been good, five years from now “property should return to being a boring asset class” and revert to an income-based product.

Cash/higher competition
The renewed attention from investors has raised one particular concern among advisers in the recent past, namely a surplus of cash. Given the throng of investors that have thrown money into the sector over the past two years, fund managers have found themselves racing against each other to secure the best deals.

Notably, global property services firm DTZ reported a 15 per cent rise in the amount of available capital targeting property globally over the first half of the year, to $408bn (£260bn), and this increase has come from a variety of sources, including unlisted property funds, listed property companies and institutions/sovereign wealth funds.

Informed Choice managing director Martin Bamford says cash a perennial issue for property funds. He says: “They either hold too much, diluting otherwise attractive yields from the property asset, or too little, risking lengthy delays when redemption requests are made by investors.”

But looking at the present backdrop, Bamford says it appears funds are becoming more fully invested. However, he adds that it was not so long ago that cash balances of more than a quarter of funds’ assets were more common.

McLennan cites a common problem for managers in the sector: “The cash went up as a deal we were looking to place did not pass our diligence checks and at the same time cash was still being invested. But by the end of July it had fallen back to 12 per cent.”

The prolonged period of ultra-low interest rates has naturally been beneficial to commercial property, and concerns are being raised in some quarters that a tightening of the cost of borrowing could hit returns. However, managers appear sanguine in the face of the new fiscal cycle.

Analysis carried out by M&G suggests that the relationship between the yields on prime commercial property and interest rates is not as straightforward as is widely assumed.

The research asserts that while UK real estate and government bonds are both affected by changes in the economic environment and the subsequent movements in interest rates, asset class-specific factors such as supply mean the relationship between them is not clear-cut. Consequently the property market tends to take longer to react to new information, and changes in property yields happen more slowly than in the bond market.

Fund picks
In terms of the portfolios that advisers and fund selectors have been backing, McDermott rates the 2010-launched £199m F&C UK Property fund and Henderson UK Property, while Bamford regularly recommends the £1.4bn Ignis UK Property vehicle – the latter vehicles have achieved a 40 per cent total return over five years.

From a property shares perspective, McDermott also tips the Premier Pan European Property fund, which is up 72 per cent over five years. The portfolio has about half of its assets invested in the UK, with a further 20 per cent and 12 per cent spread respectively across Germany and France.

McDermott says: “While the fund will clearly be more correlated to equities on a rolling short-term basis, property shares funds in general tend to be more aligned with property itself over the more medium term.”

Square Mile Investment Consulting and Research has on its property list the Aviva Investors Property Trust, M&G Property Portfolio and the Henderson UK Property and Standard Life Investments UK Property funds.

Commenting on the Aviva proposition, which has delivered a 36 per cent return over five years, Square Mile senior investment research analyst John

Monaghan notes that about 25 per cent of the fund is invested in assets that have rents linked to the Retail Prices Index.

This is complemented by properties where value can be added through active management, such as refurbishments and the early renewal of leases to ensure high occupancy rates.

Monaghan says: “Aviva has a strong heritage in managing property assets and this fund has one of the longest performance track records within the sector.”
Notably, not a single commercial property fund presently inhabits Hargreaves Lansdown’s ‘buy’ or Wealth 150 list. Laith Khalaf, senior analyst at the broker, says: “There is nothing we like enough in the sector to put our stamp on.

“Open-ended funds, which invest in property companies and trusts, do not face the same liquidity problems as those which invest directly into property.

However, these funds are more correlated with equity markets and so do not add the same level of diversification to a portfolio as a commercial property fund.”

However, from the point of view of closed-ended funds, Killik & Co head of research Mick Gilligan says that given the uplift in the asset class the group is not actively buying it, but there are “a number of investment trusts we are happy to hold”.

One of these is the £923m LondonMetric Property, a UK real estate investment trust, which invests chiefly in out-of-town retail and distribution. Up 47 per cent over five years, it is despite its name, Gilligan says, “a Nationwide investment but it retains a bias towards London and currently it has
a focus on warehousing and retail”.
Another fund that Gilligan rates is the £702.6m Hansteen Holdings portfolio, which has investment across Northern Europe as well as in the UK. With a total return of 68 per cent over the past five years, it has an “excellent track record”, according to Gilligan. “The business buys industrial property which is out of favour and improves them in order to sell on,” he adds. He also favours the £118.8m GCP Student Living fund, which listed in May last year and has since delivered a return of 15 per cent.

Gilligan says: “It invests in finished student accommodation in and around London. This is a sector in very high demand, with string occupancy rates, and the portfolio is currently yielding about 4 per cent.”

Looking ahead
Not everyone, however, is convinced about property’s popularity. Marcus Brookes, head of multi-manager at Schroders, has zero exposure to the asset class. In fact, the last holding he had in the sector was in 2007.

He points out that commercial property has been in a bull market since interest rates peaked in 1981 and since that time, when the 10-year US Treasury yield was at a record high of 15.8 per cent, the thriving bond market has underpinned that bull market. He says: “The best time to own commercial property is when interest rates are relatively high and falling. With that in mind, today’s situation is far from ideal.

“The Bank of England base rate has been close to zero for five years and is not going any lower, while bond yields remain historically very low.

“Overall, we think the potential rewards on offer from commercial property currently look extremely small given the risk of buying an illiquid, interest rate-sensitive asset class at the end of a 30-year bull market.”

Plan Money director Peter Chadborn says that lessons from the past must be learnt, given that property has proven to be subject to volatility just like any other asset class.

He says: “Although the volatility is usually undulating rather than sporadic, the lesson is hopefully clear for advisers and investors alike: commercial property is fine to incorporate as part of a long-term strategy but is not a bandwagon to be jumped on.”

Key takeaway Commercial property has staged a comeback with investors after the horrendous period bricks and mortar endured during the financial crisis. The question is, how much longer can the strong returns the sector has produced last?

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Paif the way for investors

The renewed interest and energy engulfing the commercial property sector has certainly been helped by the far improved economic backdrop. But Square Mile Investment Consulting and Research senior investment research analyst John Monaghan notes there may be an additional reason for the jump in attraction.

He says: “The increased interest in commercial property could also be driven by more funds transitioning to Paif (Property Authorised Investment Fund) structures which means that eligible investors, such as charities, Isa and Sipp holders, can now receive income distributions gross of tax.”

Paifs are a relatively new phenomenon. Introduced originally back in 2008 by HM Revenue & Customs, the establishment of the format was an attempt to create a more flexible and tax-efficient environment for property investors.

As Kames Capital, which earlier this year launched the Kames Property Income fund, explains: “Paifs shift the focal point for taxation on property investment income and interest away from the fund and toward the investor. This means for tax-exempt investors, all property income and interest is automatically paid gross of tax. Alternatively, the tax-exempt investor can opt to have such income reinvested into the Paif. For non-exempt investors, the 20 per cent tax on property income and interest is applied as before and paid to HMRC.”

The recent past has witnessed a number of funds switch to this more investor-friendly fiscal structure. The M&G Property Portfolio became the first fund to transition over to a Paif structure in January 2013. Since then the likes of Standard Life Investment UK Property, Ignis UK Property as well as the Legal & General UK Property funds have followed suit.

Gavin Haynes, managing director at Whitechurch Securities, notes Henderson has recently changed its fund from a unit trust to an Oeic structure, which will pave the way to convert to a Paif. He adds: “Many property unit trusts have converted to Paif structures. Property unit trusts are subject to 20 per cent tax on income generated. However, within a Paif, rental income generated is taxed in the hands of the investor. This means it is particularly tax efficient if held within a pension and Isa wrapper.”