A long-awaited resurgence in UK commercial property has finally come through over the past year. Capital values reversed in May 2013 with a small positive growth of 0.01%, having fallen for eighteen consecutive months, according to Investment Property Databank’s monthly index. Although a meagre increase, this growth then continued to gather pace, with capital values rising 0.6% in September, overtaking income as the principal component of performance and recording the highest monthly rise since April 2010.
The IPD UK All Property index returned a solid 15.2% for the three-month period ending 30 November 2013, led by the offices and industrials sectors. Although retail has continued to lag, capital values in the retail sector rose in November for the third consecutive month after nearly two years of declines. Offices around the UK have recently been reporting an upturn in all regions, except the South West, although this growth in UK offices has been predominantly driven by the South East market. The industrials sector has also been opening in all market segments as investors are showing a greater appetite for the attractive yields on offer, accepting assets with shorter leases with the aim of capitalising on future expected increases in rental values.
While there is much to keep investors constructive on the commercial property market, the polarisation in the valuations of prime and secondary property assets has continued to dominate returns. The yield gap between prime and secondary assets has somewhat narrowed as investors’ appetite for higher risk secondary assets has improved, but prime holdings (typically characterised by good locations and long, secure leases) have continued to command higher premiums, buoyed by their limited supply. However, in a recent report, DTZ property services have noted that secondary property is expected to outperform prime on a total return basis from 2014 onwards. This is also in keeping with the views of managers of property funds that we monitor at Morningstar OBSR, who expect the rest of the South East and other regions to catch up with central London as the high yields available in the provinces are attracting attention, even from overseas investors who until recently were solely bidding on trophy assets in central London.
The ongoing upbeat newsflow from UK commercial property and the sizeable move down in gilt yields have both contributed to the strong inflows into the IMA Property sector so far this year. Although a positive development for the sector, some fund managers were struggling to find suitable investments earlier in the year when the market was saturated and volumes were low, leading them to hold elevated cash levels. The extent to which fund managers struggled with the high levels of cash was largely driven by the flexibility of their mandates. Fund managers who were able to invest in REITs or equitise their cash were arguably less pressured to invest hurriedly.
Indeed, this highlights a crucial mismatch between the open-ended structure of property funds and the illiquid nature of their underlying investments. This becomes particularly evident at times of increased inflows or outflows, which mostly correspond with turning points in the property market. In fact, direct UK property funds have on average struggled to outperform the IPD UK All Property Index through time. As the IPD index continues to rise, substantial cash holdings in funds – necessary to fund outflows, acquisitions and developments where applicable – have remained a drag on returns, particularly in the environment of very low interest rates in the UK. Also, the index does not account for any fees or transaction costs and these act as additional obstacles to fund returns.
For investors seeking property exposure, there are some solid UK property funds available. At Morningstar OBSR, we monitor a number of these, including M&G Property Portfolio, which we view favourably. Threadneedle UK Property Trust offers a different flavour of property investing. It focuses on higher yielding assets which are often just outside the prime real estate segment. We also have high conviction in the lead managers of the Legal & General UK Property trust who are highly skilled and benefit from the backing of a well-resourced property team.
M&G Property Portfolio is run by seasoned manager Fiona Rowley, who has worked in the property team at Prudential Property Investment Managers (PruPIM) since 1994. Mrs Rowley was recently joined by co-manager Justin Upton. The duo run a diversified fund, both by property-type and industry. Their investment process combines market forecasts and research views on rental growth, depreciation rates and risk premium levels with detailed market knowledge. M&G has a strong heritage of investing in property through its PruPIM division. We consider this fund to be a good proposition in this specialist area.
Threadneedle UK Property trust offers a different flavour of property investing. It focuses on higher yielding assets which are often just outside the prime real estate category. Risk is mitigated by diversification, and by investing predominantly in existing buildings, keeping property development risk to a minimum. The fund managers, Don Jordison and Chris Morrogh, leverage the resources of Threadneedle’s well-resourced property team, including property management and investment professionals. The managers launched the fund in February 2007 and maintained a low exposure to the property market until 2009, when they began to purchase assets through the bottom of the market. This exemplifies the managers’ valuation-conscious approach well. We consider this fund to be a worthy proposition in this specialist area for investors who understand its risks.
The Legal & General UK Property trust is managed by Michael Barrie, who joined in November 2005 and Matt Jarvis, who was promoted to co-manager in March 2010. The commercial property division within Legal & General is well-experienced and aptly-resourced with over 40 investment professionals. Top-down research shapes the managers’ sector preferences for the fund. In terms of property selection, they seek to acquire arguably undervalued assets. The trust has the ability to invest in REITs and property derivatives and uses these as a resource for hedging risk, reducing costs and managing property and cash exposures. We have high conviction in the skill of the lead managers and note they enjoy the support of the wider property team at the firm.
This article originally appeared in January's Professional Adviser magazine
