The toxic combination of a weakening economy and the legacy of a spectacular boom and bust has left commercial property off most investors' buy lists. It remains the one high-yielding asset not to benefit from the huge asset flows in income funds of all kinds. Yet there are signs this is starting to change as expert investors take an increased interest in the asset class.
Commercial property was hit hard by the crisis. Valuations were high and vulnerable, and there were structural pressures as consumer spending dropped and the economy weakened. Commercial property valuations also had to adjust to the impact of the internet on the high street. The results were well-documented, with many commercial property funds having to close to redemptions as investors scrambled to leave the sector.
But there are signs that after five years in the wilderness, investors may be returning. Multi-asset managers are increasingly reinvesting in the sector. In the Mixed Investment 20-60% shares sector, the Fidelity Multi-Asset funds, Schroder Managed Monthly High Income fund, plus HSBC and Kames multi-asset funds all have relatively high weightings to commercial property.
Mark Burgess, chief investment officer at Threadneedle, who has just upped the weightings across the group's multi-asset funds, points out that the asset class yields over 6% and that fundamentals are improving with the UK economy slowly improving and unlikely to return to recession. Others have started to look to commercial property as a potential alternative to fixed income. For example, Bill McQuaker, head of multi-asset at Henderson Global Investors, has recently moved back into the asset class for the first time since the credit crisis, believing that it is a less crowded trade than fixed income and less vulnerable to rising interest rates.
Investec Wealth & Investment's asset allocation committee has recommended a shift into commercial property, increasing the weighting in its balanced portfolio from 2.5% to 5.5% of total funds, equivalent to a £500 million increase in the amount of total UK client money invested in the asset class. Chris Hills, chief investment officer says: "It offers a relatively attractive level of income, with comparatively low volatility, but also encompasses participation (as a real rather than nominal asset) in future economic growth and potential protection against inflation."
But might investors already be too late? Commercial property share funds have already seen some strong performance. The top 10 funds in the IMA Property sector over three years are all focused on property shares, and have all delivered over 30% over that period.
There are structural reasons for the outperformance of property shares over classic bricks and mortar funds. Alex Ross, manager of the Premier Pan European Property Share fund, says: "In 2009 there was equity raising from a number of property companies. They came and bought property at a low point. Over the past few years they have been the key beneficiaries of the recovery in capital values in some of the major cities.”
Ross points out that many of these companies also had a unique cost of capital advantage. They could borrow at low rates, by issuing corporate bonds, sometimes for as little as 2-3%, while earning far higher rates on their rental income. Ross says this was 'highly earnings accretive' and continues to be so for a number of companies.
That said, valuations have caught up in many areas and it is forcing managers outside 'prime' London property. Hills says: “Capital values outside London have hardly recovered from the lows of 2009 and yields are much higher than in London. We believe that some of the weight of money going into London in the past few years will extend into the UK’s regions as confidence in our economic recovery increases.”
Ross is looking to areas such as the technology belt in London, an area from Kings Cross to St. Katherine's Dock, skirting the City. “London is being driven by media and technology companies and these are the areas with substantial growth potential.” He believes that yields are likely to be flat, and therefore finding properties with a growing yield is increasingly important.
Ross is also looking to some well-let assets outside London, saying: “All the money in the last three years has gone into areas with the safest income. You need to be very careful in secondary property, but some of these areas have seen a 50-60% decline in capital values and are now paying yields of 9-10%.”
Until relatively recently, the direct bricks and mortar funds had trailed property share funds. They had not been able to take advantage of the cost of capital advantages of larger property companies. However, property share funds have suffered in the recent volatility because they are more correlated to equity markets, bricks and mortar funds' qualities as reliable providers of stable, diversified income returns came to the fore.
Commercial property is not wildly cheap—property securities have already had a good run and bricks and mortar funds do not necessarily have the same cost of capital advantages. However, compared to other high yielding assets, commercial property has been neglected and may therefore be due for a renaissance.
