RSMR’s Smith: What to make of property after Brexit

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The UK commercial property market had been going through a change in investor sentiment even before the announcement of the date of the UK’s EU referendum vote, mainly due to the expectation of much lower returns relative to the previous few years.

Some retail funds changed their pricing basis on the back of reduced investor interest and negative fund flows, and the negativity increased in the lead up to the vote itself. Property transaction volumes saw a large fall in the second quarter and the UK’s vote to leave the EU triggered a large number of investor redemption requests, which, in turn, led to many retail funds suspending dealing and most funds applying fair value market pricing adjustments.

The property market saw a short-term fall in pricing, more noticeable in Central London, but there has been a fair degree of stabilisation since.

The UK economy has been stronger than many expected following the EU referendum result with an interest rate cut and the re-introduction of quantitative easing from the Bank of England helping to provide stability and build confidence about the short-term outlook.

The UK commercial property market itself has started to recover and has returned to producing small positive monthly returns, albeit at lower levels than prior to the referendum vote. The combination of a fall in property valuations and the large fall in the valuation of sterling versus overseas currencies has made UK property much more attractive to overseas investors and there has been anecdotal evidence of interest from overseas buyers.

From a UK investor’s perspective, asset class returns are expected to be reasonable through the latter part of 2016 and into 2017 but there is the general acceptance that returns will be much lower than the double-digit returns seen in the last couple of years.

Direct commercial property is traditionally recognised as an income-orientated asset class over the medium to long-term with capital growth fluctuations providing the main volatility and the possibility of greater positive or negative returns over the short-term.

The fundamentals of the asset class have not changed that much during recent months but we would expect returns to be driven by income with limited capital growth and rental growth becoming an increasingly important performance driver.

Liquidity remains a key investor concern and regulation may be introduced to address, this but investment managers have been paying close attention to their liquidity profiles and have generally increased their cash levels from pre-EU referendum levels.

Returns from the property securities sector have been very strong in recent times, as this typically interest rate-sensitive sector has been a major beneficiary of very loose monetary policy, falling/negative interest rates, falling bond yields and falling inflation levels.

The last six to 12-month period has seen a disconnect between the performance of different regional property securities markets with Europe, and particularly the UK, lagging behind – the UK being very negatively affected by the referendum vote.

The large fall in sterling has led to very strong returns for sterling investors from overseas markets, especially Asia and the US, with the postponement of interest rate rises a key beneficiary for the latter.

Over the very short-term there has been increasing talk of higher inflation levels, particularly in the UK as a result of the currency weakness. This has led to rising bond yields, which, in turn, has negatively affected the property securities sector, demonstrating the potential for weak returns should inflation and bond yields rise from current levels on a more global basis. This is more relevant for developed markets, particularly the US, Europe and Japan.

From a portfolio perspective, direct commercial property provides greater diversity and a lower correlation to other asset classes than property securities and should be considered as the core part of any property exposure.

There are nuances between individual funds, including how they treat cash, if they invest in REITs/securities, property sizes, prime or secondary property focus etc. but their objectives are very similar and they are generally run by experienced managers with large resources in support.

Our direct commercial property fund choices would include:

F&C UK Property – A ‘pure’ bricks and mortar fund that deliberately targets smaller property lot sizes, managed within a separate business within F&C

Aberdeen UK Property – Invests mainly in prime properties but can invest a small proportion in property securities; well-resourced property team

Threadneedle UK Property – Another ‘pure’ bricks and mortar fund but this deliberately targets the secondary property market with a strong focus on high income

Property securities provide satellite exposure within the overall property asset class. Over the short-term they can have quite high correlation to equities but this reduces over the longer-term and they provide the opportunity for global diversification.

Our property securities fund choices would be:

First State Global Property Securities – This fund invests for total return and focuses on higher quality properties using its global research resources

Schroder Global Cities Real Estate – Looks to identify growing global cities and invest in real estate companies that are well-positioned to benefit from this growth

Stewart Smith is investment research manager at RSMR.