On September 6, the London Underground had its busiest morning in 18 months. Congestion levels were almost back to pre-Covid highs. This suggests the death of the office market may have been greatly exaggerated, even in this brave new era of agile working. Investors in commercial property have started to take note.
2020 was a grim year for commercial real estate. Uncertainty over the future of office working, the ongoing gloom in the high street, delayed rents and sliding capital values forced open-ended property funds to shut up shop (again). Funds in the IA Property Other sector dropped by an average of 7.2% over the year, while UK Commercial property investment trusts fell 13% (source: Trustnet). The only bright spots were logistics and certain industrial property, which benefited from the adoption of online shopping.
The sector has seen a significant recovery since the start of 2021. The average IA Property Other fund is up 18% (source: Trustnet to 9 September), making it the fourth best performing sector for the year to date. Commercial property investment trusts have seen a similarly strong performance.
Pessimism Reversed
Partly, this is a simple case of an over-reaction, corrected. James Klempster, deputy head of multi-asset at Liontrust Asset Management, says: “What you can say with confidence is that markets always over-compensate on the way up and the way down. Markets have spent two years over-emphasising the risks that people would never return to the office and anticipating a sea-change in behaviour. The reality is somewhere in the middle. Undoubtedly you can be productive without being in the office, but we didn’t roll back years of evolution. People still want to co-operate. We are now seeing a reversal of that excessive pessimism.”
Equally, Gavin Haynes, investment consultant at Fairview Investing, says investors have started to recognise that the market is more nuanced: “There are clearly some parts of commercial property that are still in structural decline, such as high street retail. However, there are others that are going from strength to strength. There is a change in consumer habits, so the growth in warehouses and logistics remains strong.”
The recent bounce may also reflect some hard work among property managers to re-engineer their portfolios. For some, this had started before the pandemic, as it became clear that high street retail, or certain types of office space would never recover, while areas such as logistics had a brighter future.
The pandemic also accelerated "asset management" on existing buildings – reconfiguring buildings to alternative uses or improving them to reflect the new working reality. Jason Baggaley, fund manager on the Standard Life Investments Property Income Trust (SLI), says: “The death of the office is overdone, but the use of an office will change … we need to provide offices where people want to go and work, that means providing the occupiers with a level of amenities.”
Greening Buildings
For many fund managers, this also means working to improve the green credentials of their portfolio. Aberdeen has been having conversations with tenants on improving the environmental credentials of its buildings, including installing photovoltaic panels (PV) and electric charging points. They are now looking at the embedded carbon within a building and for new purchases, are paying close attention to a building’s carbon rating.
This work has helped put some commercial property trusts in far better shape, giving them a better tenant profile. David Miller, executive director at Quilter Cheviot, believes this shift could create real value in the sector over the coming years: “There is a move to more intelligent buildings and offices have got to be more environmentally friendly. This is going to be a huge project over the next decade.”
The question is whether this is likely to deliver good returns for investors from here. These initiatives come with an upfront cost and, while they should deliver higher yields and stronger capital appreciation as a result, that’s not assured. This may be even more of an issue where a wholesale change of use is needed. Haynes gives the example of certain city centres, currently dominated by retail that will almost certainly need to move to multi-use areas – with some residential and some leisure. “As an asset class, it will adapt, but it means some assets are going to be in flux for some time.”
Income Matters
Klempster says the shift may prove rewarding, but it’s not why he invests in property: “We prefer high quality, non-correlated assets that are less economically sensitive. As such, we’re focusing on areas such as care homes, social housing or health centres. These have long leases and the cash flows are government-backed.” The problem, he says, is that while it may regenerate, buildings may change purpose, in the meantime there is a speculative element: “We don’t want to be reliant on capital appreciation. We prefer the total return to be more biased to income.”
Quilter Cheviot's Miller, in contrast, believes there are opportunities, but investors need to cast their net widely: “Reits are a good place to start. They have liquidity to get in and out and allow us to look across the world, where conditions may be different”. Fairview's Haynes says investment managers will need to be extremely flexible to manage this new environment. That means investors should look at investment trusts or open-ended funds investing in Reits. He likes funds such as TR Property (TRY) or Fidelity Global Property, which invest sensibly in well-diversified portfolios with good teams.
It is worth noting that direct property investment through open-ended funds has little support. Few believe this approach gives managers the flexibility they need to manage a commercial property portfolio today. Aegon and Aviva have already announced plans to wind up their commercial property portfolios and others may follow.
