Commercial property is an asset class that would be expected to perform poorly in times of recession, but with many of the longest established funds trading at substantial discounts to net asset value following sharp share price falls this year, could it be that the asset class is becoming a bargain?
And in addition to cyclical concerns around the economic outlook, there are longer-term considerations around the future of the High Street and of office space, as remote working and online retailing disrupt an asset class that was once a bedrock of many client portfolios.
Darius McDermott, investment adviser to the VT Chelsea range of multi-manager funds, says: “There are traditionally two reasons to have property funds in a portfolio. The first is to have diversification away from equities, while property is also primarily an income asset.”
I think commercial property has a deserving place in many multi-asset portfolios, but they do require specific consideration.
“While the challenges around remote working are likely to have a major impact, valuations are also very cheap, with most of the trusts trading at a minimum at 20 per cent discount to their assets,” adds McDermott.
Ben Seager-Scott, head of multi-asset funds at Tilney, says: “I think commercial property has a deserving place in many multi-asset portfolios, but they do require specific consideration as to their investment characteristics.
“They are generally illiquid, ‘real’ assets so can perform a useful diversification role in a portfolio and offer a potentially attractive and steady revenue stream from rents – but of course they are also subject to economic factors, and the listed vehicles can come with more equity-like volatility, especially in sharply falling markets.
“So they definitely require specific consideration, be they mainstream or specialist.”
Mick Gilligan, who runs the model portfolio service at Killik & Co, a wealth management firm, says one of the reasons property fund share prices have fallen so much this year is because interest rates have risen, and property funds, in addition to investing the cash raised from investors, borrow money to invest further.
Higher interest rates increase the cost of debt repayments and mean less of the rental income is available to investors as more of it goes to debt repayments.
McDermott says the share price falls reflect the market anticipating the higher debt repayments in the future, as most property funds borrowed cheaply in recent years but when they come to refinance, will have to pay much higher interest rates.
I also think one should avoid retail right now, unless they are very long leases to very high-quality companies.
A phenomenon of recent years has been the growth of alternative property investment trusts, in areas such as warehouses and supermarkets.
Gilligan is particularly concerned about the impact of higher interest rates on this part of the market, saying: “I think all real estate trusts are sensitive to higher yields/rates. Those with a bias towards logistics have been particularly hard hit. I think this is mainly because this area was the most highly rated – that is, yields had fallen to very low levels and so the capital values have fallen more sharply as these yields have risen.”
McDermott says the other way in which higher interest rates are negatively impacting the share prices of property investment trusts right now is that the income available from property funds, with all of the risks they carry, is relatively less attractive when the income on lower risk assets such as government bonds and cash rises.
Gilligan says it is this factor, more than concerns around the impact of remote working on the property market, that is responsible for the drop in prices this year.
His view is that: “Anecdotally, demand for high-quality offices [with good environmental ratings] is strong. But secondary assets [that is, non-prime] that need investment to bring them up to date on their environmental ratings are probably at risk.”
Bringing a number of those themes together, Gilligan says the level of debt owed by commercial property companies is relatively low now.
He says: “Table one [below] highlights the investment trust [UK property] sectors ranked by gross gearing (debt as a percentage of gross assets). The residential trusts are the most highly geared and UK commercial property (UKCM) looks the most attractive when you take leverage, discount, yield and portfolio quality into account.
With around 20 per cent of leases expiring in the next three years, there should be good scope to raise rents and help keep income ahead of inflation.
“Almost two-thirds of the UKCM portfolio is in logistics and industrial assets. While valuations in these areas have been hit hard, they still look very attractive in terms of supply/demand. The portfolio boasts some high-quality tenants such as Ocado, Amazon and the UK government.
“There is no disclosure of tenant by credit rating, but the tenant list is long and very diverse. Voids are estimated to be around 2 per cent, which is low. The company does not disclose explicit inflation linkage.
“However, the reversionary yield – that is, yield if all properties were re-let at current market rates – was estimated (by Kepler) at 8.7 per cent in the final quarter of 2021. So, with around 20 per cent of leases expiring in the next three years, there should be good scope to raise rents and help keep income ahead of inflation.
| Group/Investment | Ticker | Latest Discount (Cum Fair) | Portfolio Yield | Latest Gross Gearing (Cum Fair) % |
| Residential Secure Income Ord | RESI | -20.0 | 3.9 | 90.2 |
| Regional REIT Ord | RGL | -37.5 | 7.5 | 72.4 |
| Triple Point Social Housing REIT Ord | SOHO | -39.5 | 4.7 | 57.9 |
| PRS REIT Ord | PRSR | -25.8 | 4.2 | 55.4 |
| Ediston Property Investment Company | EPIC | -33.2 | 5.6 | 55.0 |
| Civitas Social Housing Ord | CSH | -46.3 | 5.0 | 51.5 |
| Schroder Real Estate Invest Ord | SREI | -41.3 | 4.9 | 41.4 |
| Warehouse REIT Ord | WHR | -29.2 | 4.4 | 35.1 |
| CT Property Trust Ord | CTPT | -41.5 | 4.7 | 35.1 |
| Supermarket Income REIT Ord | SUPR | -11.0 | 3.8 | 33.4 |
| Balanced Commercial Property Ord | BCPT | -33.0 | 4.3 | 31.5 |
| Target Healthcare REIT Ord | THRL | -22.6 | 5.5 | 31.3 |
| Tritax Big Box Ord | BBOX | -41.3 | 3.2 | 30.1 |
| Abrdn Property Income Trust Ord | API | -48.7 | 5.2 | 27.4 |
| Home REIT Ord | HOME | -27.7 | 26.6 | |
| AEW UK REIT Ord | AEWU | -25.1 | 6.6 | 26.2 |
| Impact Healthcare REIT | IHR | -9.3 | 6.3 | 23.7 |
| Urban Logistics REIT Ord | SHED | -24.0 | 3.4 | 22.3 |
| Custodian REIT Ord | CREI | -25.4 | 6.0 | 21.7 |
| UK Commercial Property REIT Ord | UKCM | -38.3 | 3.7 | 20.1 |
| LXI REIT Ord | LXI | -15.4 | 2.2 | 9.7 |
| Life Science REIT Ord | LABS | -29.0 | 0.1 | 0.0 |
Simon King, chief investment officer at Vermeer Partners, says the key consideration for investors should be to focus on property funds that have assets with rents that rise in inflation, as this both protects the spending power of the income, and retains the attractiveness of the asset class relative to bonds and cash.
He adds that one should ensure that the property valuations of any fund into which an adviser or wealth manager invests “are done by an independent entity, at least one of the big property fund providers, I think their valuations must be written by [the fairytale author] Hans Christian Andersen.
“I also think one should avoid retail right now, unless they are very long leases to very high-quality companies.”
Property investing plays a very prominent role in the psyche of many British clients; whether that lustre can survive the coming recession and the structural changes afoot in the industry is something that will determine the returns achieved by many portfolios in the years to come.
David Thorpe is special projects editor of FTAdviser
