Investors have seen a remarkable recovery in property market conditions over the last 18 months.
The UK commercial property IPD index peaked in August 07 and subsequently fell over 35% bottoming in July 09. Lending markets almost completely closed in some areas and at the same time demand from tenants was weak. UK property funds experienced significant redemptions prompting them to sell properties into a falling market in order to raise cash.
From its nadir the IPD index has recovered more than 25%, as at the end of August 2010, in a rebound that has surprised many observers. Lending conditions have eased and a flurry of international investors have re-entered, supporting this recovery form an arguably oversold position. As recent as two years ago, UK property funds were trying to raise cash but now are in the reverse position, making significant property purchases in 2010 on the back of huge fund inflows to the sector.
OBSR analyst meetings with UK property managers have highlighted these and several other interesting trends in market. Although OBSR does not formally rate direct property funds, we do recommend a number of high profile funds and undertake quarterly reviews with the managers.
Fiona Rowley, manager of the M&G Property Fund, believes that the rally in prime property is over and that attention has now shifted to better quality secondary property. The differentiation between prime and secondary property remains extremely high but the manager has no desire to chase this gap at this stage. She sees the positives for the markets largely focused around the relative attraction of the underlying yield compared to other asset classes and the opportunity for good managers to work their portfolios hard through good active management. The negatives are the absolute level of yield, particularly in the prime sector and the fact that rents in aggregate are still declining. The fund itself is still attracting fresh flows with cash standing in double digits.
Gerry Ferguson, manager of the SWIP Property Fund cites the fact that we have already seen a near term peak in capital values which are now stabilising. He argues that the quality of income will be the priority in the next few years and this will be the key driver of portfolio returns. He points out that rents in aggregate are still declining and that only London offices have seen positive rental growth. As a result he anticipates further declines in Capital values in the next 2 years for property in aggregate. In terms of positioning, he favours industrial over provincial offices and retail units but is looking to increase exposure to London offices. The fund in common with other direct property funds has a high cash weighting and has experienced strong fund flows. The manager has initiated positions in both REITs and derivatives to manage his cashflow with the direct property exposure accounting for around 70% of the portfolio currently.
Philip Nell, manager of the AVIVA Investors Property Trust argues that the market has slowed abruptly in recent months and he believes that property in aggregate is at or close to fair value. He sees active management adding significant value in the next 2 years as rental growth remains flat. Unlike some of his peers, he is not convinced that the improvement in rental values in London is sustainable given that firms are transitioning to new properties rather than the market witnessing new entrants. He is stressing the quality of income as the main priority as we enter 2011. Once again the fund has double digit cash weighting in line with the peers.
Michael Barry and Matt Jarvis, managers of the L&G UK Property Trust, expect cash in their fund to drift back up towards the 20% level. On the back of strong inflows, they have already executed 10 property transactions this year – a high number for a retail property fund of this size. The fund size has increased significantly and small lot sizes have a decreasing impact on fund performance. Consequently the managers have recently executed some of the largest purchases ever for this fund. They argue that the skill-set is the same for larger properties, however the competition is different with prospective buyers more likely to be institutional investors than individuals or family offices. Following the strong rise in asset values so far this year, they are now seeing fewer exciting opportunities. Prices appear to be flattening in their view, and they are no longer rushing to add further properties to the portfolio. Despite the assets within the fund performing well, the high level of inflows in a rising market has resulted in underperformance for the fund. They have mitigated this to an extent with well-timed trades on IPD futures – a derivative contract that reflects performance in the UK property market.
The key common points among the fund managers appear to be:
-- Prime (high quality and good location) property remains the main focus of property fund managers, with some exceptions
-- While rental values were stable over September, this continues to reflect growth in Central London offices while rents in other markets remain weak
-- Having made a large number of purchases through the recovery, managers are now more cautious, on the view that markets are flattening and the supply of quality properties at a competitive price is more scarce
-- Active Management of existing properties in their portfolios is expected to be a major driver of returns going forward. Active management involves working with tenants to maximise occupancy and rental return, and in some cases adding value through refurbishment or development.
The income aspect of property is attractive but the significant fall in property markets during the credit crunch should remind investors that direct property should generally be a long-term investment.
This article was first published on Ifaonline.co.uk
