Can property continue to deliver?

Property has seen a surge of popularity in the UK in recent years, with investors ploughing money into property funds as they seek additional returns in a low-yield environment. But with talks of residential housing shortages and supply constraints across UK property, is the outlook for the sector still as rosy?

The IA Property sector has been in the top three most popular investment sectors every month bar one for the past two years. Last year saw £3.82bn of flows into the sector, according to IA data. Inflows have continued to be steady this year, with the first three months alone seeing £832m of net retail sales.

The sector benefitted from investors looking elsewhere for yield as bond market returns plummeted.

“The fund driver over recent years has been the impact of QE,” says Andrew Allen, global head of property research and strategy at Aberdeen Asset Management. “If you have interest rate policy that sets income returns very low as we’ve seen with fixed income and for retail investors the savings rates in most accounts is low, just by the law of gravity really investors will look for asset classes that produce relatively high returns and relatively high yields and income.”

But with so much cash chasing increasingly fewer opportunities, can the double digit returns property funds delivered last year continue?

“I think there could be some investors looking at past performance and the extremely strong past couple of years, but we will not get the same level of returns over the next couple of years that we got in the past couple of years,” says Mark Meiklejon, investment director of real estate at Standard Life Investments.

While returns are expected to continue to be strong, at least in the short-term, they are likely to be high single digits rather than double-digits, he adds. Across the next three years the asset class will see “fairly healthy high single digit returns”, he says, but they will be frontloaded, with the next 24 months seeing the bulk of that growth, after which property markets will flatten, he predicts.

Capital growth will continue in the coming year, predicts Ainslie McLennan, head of UK balanced funds at TIAA Henderson Real Estate, but thereafter total returns will come predominantly from income.

Caspar Rock, CIO at Architas, agrees that as property did “very well last year…with returns exceeding almost all expectations,” this year will see more of a coupon story with a little bit of capital growth.

For this reason, the Henderson UK Property OEIC that McLennan runs is focused on primary, good quality properties in good locations with reliable tenants, she says.

“I want certainty on the income line. If you lose a tenant in a good location and good quality building the chance is much higher of re-letting it than in a secondary location in a fragile occupier market,” she says.

However, with prices in London reaching record highs Allen thinks some of the second-tier cities in the UK, such as Birmingham, could offer potential for more growth. There has already been talk of banking giant HSBC relocating its headquarters away from London to Birmingham, and more could follow, he says.

“Many city centres of the UK have seen a lot of investment and are much more desirable places than they historically were,” he says.

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As well as hunting for reliable yields, investors have been looking for an inflation (or deflation) hedge. Property delivers this hedge with upward-only rent reviews, says Rock. “If you’re worried about deflation, upward-only rent reviews suddenly become even more attractive, if you buy something at a yield of 4.5 per cent and the yield won’t go down,” he says.

The flood of retail flows to the sector over the past 24 months has led some fund managers to be cautious about the reactive nature of retail investors, and so potential outflows when market conditions change.

A sharp rise in interest rates by the Bank of England, although unexpected, would be detrimental for the property sector as the relative value of the asset would look less attractive than bonds.

While at the moment property is a little expensive on an absolute basis, compared to historical values, relative to other asset classes it offers good value, says Meiklejon. But if that shift in bond yields occurred, the story could change.

However, rapid rate rises are not on the cards for many managers, with most expecting a slow inching up in rate rises, or around 25 basis points each time.

Rock thinks it could be even slower than that. “Everyone says they will put it up 25 basis points, but they might just put it up by 10 basis points and have a look. Creep it up bit by bit,” he says.

Still managers are cognisant of liquidity.

“Even though the flows are net inwards, we are very alive to the fact bonds will look attractive at some point or something will change the macro perspective and alter people’s views of their percentage holding of different asset classes,” says McLennan.

For this reason many property funds are focused on cash and liquidity, with average cash holdings running between 10 and 20 per cent, or higher, depending on the sentiment at the particular time.

For McLennan, while she sees REITs as more volatile and not an ideal holding, she has 3.5 per cent allocated to them to boost the fund’s liquidity. From there out the team ranks the liquidity of each of the holdings, knowing which they can sell more rapidly than others.

A new government in Downing Street means potential legislative changes could occur that help or hinder property market growth. That said, much of the pre-election rhetoric focused on solving the demand issues rather than supply, says Rock. For example the Conservatives pledged to extend the Right To Buy scheme to those in social housing, as well as council housing.

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Two factors, outside of any interest rate rise, that could boost supply in the market is easing planning laws and focusing on property companies that are sitting on landbanks, Rock adds. “Anything they do to address supply would be great,” he says.

While growth in UK property may be slower this year, it’s a different story in Europe, which is offering good prospects, says Meiklejon. While the UK and the US saw strong growth in property in recent years, Europe has lagged and is ripe for solid performance in the next three years, he adds.

Key takeaway: The property sector is likely to underperform last year’s high returns but inflows continue. Any rate rise or improvement in bond yields could see large outflows from the sector.