Commercial property: it’s harder work to pick high-yield winners

Commercial property is a bellwether for the wider economy – and Brexit means investors will need to tread carefully.

Last October, the Financial Conduct Authority (FCA) proposed new rules for open-ended property funds, designed to address the illiquidity of commercial property as an asset class. In future, it said, Oeics investing in property must be prepared to act even faster at any sign of a run on their funds, suspending trading if the valuation of 20% or more of their assets is at risk of ‘material uncertainty’.

With Brexit pending, the intervention is timely. After the referendum in 2016, most open-ended property funds were forced to suspend trading in the ensuing sell-off, and there’s a strong possibility of that happening again.

Brexit hangs over property funds especially because, as Darius McDermott, managing director of Chelsea Financial Services, puts it: “Historically there’s a close link between UK commercial property and the UK economy. Brexit is definitely going to lead to a slowdown in our opinion, so we’d be cautious on a 12-month view.”

Dampened demand

Some impacts were already felt in 2018. The anticipated exodus of financial services jobs dampened demand for office properties; sterling’s decline weakened retailers; and continued uncertainty seemed to put off overseas buyers, as well as causing some of the biggest property companies to postpone their development plans.

Retail was clearly the laggard among the three segments of commercial property in 2018, in a year when some of the biggest high-street names, including Debenhams and House of Fraser, got into trouble. Office assets also did less well, especially those concentrated in London and the City or in the financial centre in Edinburgh and seen as exposed to Brexit. The industrial and warehouse segment was the best performer, with some pundits even seeing a possible silver lining in a no-deal Brexit, on the grounds that companies would be investing in greater storage capacity to keep their supply lines charged.

Overall, though, there were fewer deals and fewer international buyers in 2018. Most open-ended property funds nevertheless achieved a decent return in 2018.

As at late November, the Investment Association’s UK direct property sector averaged a 6.8% 12-month gain.

Investment trusts investing in direct property did less well: the sector was up 2.6% over the same period, reflecting the widening of the average share price discount to net asset value as investors reduced their exposure in anticipation of lower growth. In 2019, there’s a good argument that returns in commercial property will be down irrespective of Brexit, as the asset is ‘fully priced’ and capital values are expected to slip.

So what to invest in? Jason Hollands, head of business development at Tilney, says: “If you’re a yield-seeker, it is difficult to get overly excited about UK open-ended property funds at the moment. These are typically generating yields around 2.2-2.9% and this is an economically sensitive asset class, so you want to make sure you are in funds with high-quality tenants and long average unexpired lease periods that go well beyond the next couple of years, when the UK will be adjusting to life outside of the EU.”

Among the higher-quality options available he highlights an open-ended fund, Janus Henderson UK Property, and an investment trust, F&C Commercial Property Trust.

McDermott is keen on TR Property Trust, an investment trust which invests both in UK direct property and in some property shares, with an option to short stocks to dampen volatility. Investment trusts have an inherent advantage in these circumstances, as although shareholders may be selling (forcing the share price down), there is no pressure on the manager to dispose of the underlying property assets to fund redemptions.

If you’re prepared to take more of a chance on the short term, then individual Reits (real estate investment trusts, which are publicly quoted companies that own, operate and sometimes develop a portfolio of properties) or funds holding property securities could be worth considering .

Russ Mould, investment director at AJ Bell, says: “Discounts to net asset value have opened up to quite wide levels in some cases, and investors must now ponder whether this means commercial property is a value opportunity or a value trap.” A stock such as CLS Holdings, an original investor in The Shard, with assets in the UK as well as Northern Europe, could offer a hedge against a UK slowdown, he suggests. And if you think sterling is going to decrease in value going forward, investing outside the UK will pay a further bonus.

How to buy the asset class

iShares UK Property ETF – this fund tracks the FTSE EPRA/NAREIT UK index, investing in the biggest Reits such as British Land, Land Securities and Hammerson. It was down 0.1% over 12 months to mid November, but would be well placed for a rebound.

iShares MSCI Target UK Real Estate ETF – a smaller and younger fund which follows the MSCI UK IMI Liquid Real Estate Index, and holds ­ fixed interest as well as UK property equities. It showed a small gain of 0.8% over the same period.

iShares Global Property Securities Equity Index – this unit trust tracks the FTSE EPRA/NAREIT Developed Index, and is highly diversified globally. It returned 3.5% over 12 months.

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