Returns with sound foundations

Posted by Liz Rees in Weekly musings category on 24 Jan 19

Commercial property is often overlooked by investors, perhaps because they feel they have enough exposure to the asset class through home ownership and in some cases, buy to let as well. However, it has different characteristics to residential property so I thought I would outline the key features and consider the role it can play in a well-diversified portfolio.

There are 3 main sectors: retail, office and industrial plus ‘alternatives’ such as leisure and hotels, private rental residential and medical centres. Prime location assets are lower risk whereas new developments are at the higher risk end of the spectrum. As with other investments, mature assets generate higher yields than strong growth areas such as the flexible workspace sector or student accommodation.

The investment case

Investment returns come from a combination of income and capital growth. Dividends are the main component, so property is attractive for income seekers. In the UK, rents are reviewed every 5 years on an upward-only basis, whereas in Europe they are indexed to inflation.

As as a real, or tangible, physical asset, property provides a good hedge against inflation. This makes it a popular core holding for pension funds. A small pick-up in interest rates is not necessarily bad news for the property sector, unlike bonds, as it may deter new-build activity making existing property more valuable. Like commodities, land and buildings are in limited supply and well placed to retain their core value.

Furthermore, landlords can enhance returns by making improvements, for example, refurbishment or extension. This can increase the value of the assets and attract better tenants paying higher rents. Additional security comes from the fact that commercial tenants usually commit to leases of 10 years or longer. 

Therefore, commercial property should offer secure and stable cash flows, lower volatility, and diversification benefits. The sector proved relatively resilient in 2018 whilst shares and bonds retreated.

How can I invest?

In September 2018, the Investment Association (IA) introduced two property sectors: UK Direct Property sector and Property Other sector. The first comprises funds that invest directly in UK real estate assets and may undertake development. The second contains funds which invest in shares of listed property companies, direct funds with a specialist mandate and index trackers; these may focus on a particular region or invest globally.

Other ways to gain exposure are: investment trusts, passive ETFs or single company shares. Many property companies have re-structured themselves as REITs (Real Estate Investment Trusts) which have tax advantages if certain conditions are met. REITs own income producing assets (commercial or residential) and are exempt from corporation tax as long as 90% of their net profit is distributed. Rental business must account for at least 75% of both income and assets. You will find REITs in the shares section of our website along with other property companies.

What’s the downside?

Property is an illiquid asset and the transaction process can be lengthy and expensive. Valuations are carried out less frequently than other assets; while this means direct property fund prices should be more stable, property shares are still subject to the ups and down of stock markets.

Liquidity problems were highlighted in 2016, when there was a wave of selling by retail investors of direct property funds around the EU referendum. This led to the temporary suspension of a number of them, over a period of weeks or months, as they had to sell properties to meet redemptions. Closed end investment trusts, ETFs and shares do not face this issue.

Risks include tenant defaults, tax changes, and shifts in yields offered by other investments. Therefore, credit quality of tenants is important, as are length of lease and break options. However, most funds focus on lower risk, prime location assets.

Storm clouds on the horizon?

The outlook is somewhat dependent on the UK economy - we all recognise the woes of the High Street, with retailers going out of business on a daily basis. However, as one area struggles, others such as logistics and regional offices may thrive.

On the whole, the market is dominated by institutional investors with a long term horizon which provides stability, although nearly 30% of UK commercial property is held by overseas investors so it could be affected by the Brexit outcome.

Funds see plenty of opportunities

Active funds strive to find the best opportunities, including regeneration of depressed areas to capture demographic and leisure trends.

At a recent presentation, Ainslie McLennan, fund manager of Janus Henderson UK Property, outlined some of the themes they have identified. Innovative projects include: ‘landlord to service provider’ (energy efficient, well connected, sustainable assets); ‘creating collaborative spaces’ (in Bermondsey they have combined flexible workspace, living, services and leisure) and ‘serving an ageing population’ (high specification care homes).

In summary

The valuable role that commercial property can play as a diversifier for investors was demonstrated in 2018. Furthermore, a good spread of property assets should help insulate investors from downturns in any one segment of the market.

Income will be the key driver of total returns for investors in commercial property. Thus, if a steady dividend stream and, hopefully, a little capital growth from professional asset management appeals, commercial property funds may be worth consideration.

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser. 

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