the modern history
The sector was particularly affected by the financial crisis of 2008-2009. This has exposed these companies to large loans, interest costs and development risks. The market was rough and almost random, and big drops in stock prices were seen. In the ensuing years, companies arranged their home to the point that most of them are more flexible today.
Debt levels are low and existing debt has been secured cheaply in recent years – with very few companies having any medium-term refinancing requirements. A notable feature of this real estate cycle is underinvestment and consequently in short supply. Meanwhile, thanks to the crisis, managers have been much more cautious – there is a lack of exposure to development, a focus on income, which has ensured earnings coverage in general, and diversification across sectors and regions. Good assets and financial management helped the case.
As such, the sector weathered the storm of falsely rushing to the door and closing a number of open commercial real estate funds immediately following the Brexit referendum result – which remains a talking point for investors and a focus of the Financial Conduct Authority (FCA). However, the epidemic has proven more difficult. Businesses and renters struggled, rent collection rates fell, profits were cut, and discounts widened. Sentiment has only partially recovered and economic uncertainty and expectations of higher interest rates have not helped.
The sector is heterogeneous. Real estate investment trusts (Reits) tend to focus on income while developers are more looking to raise capital. There are also a variety of sub-sectors. It is an asset class that has different characteristics than others, such as bonds, renewable energy, infrastructure or commodities. But it does share a trait in common with some in that portfolio returns respond to inflation over time – although in the short-term the relationship is less directly correlated and therefore linear compared to infrastructure and renewables.
Recent research indicates that the total returns to the UK sector outpaced inflation during the period from the end of World War II to the financial crisis. The composition of those returns changed with inflation. For the first 20 years of low inflation and the 1981–2009 period of low inflation, income from rentals provided the majority of these returns. However, capital growth gained more importance during the period 1967-1981 when inflation was a problem. Looking ahead, there is no indication that it will be different this time around – capital growth must once again be on the rise to help total returns outpace inflation over time.
Another concern for some sector skeptics is concerns about the impact of Brexit. This once again proves to be unfounded. Despite the prevalence of economic uncertainty globally, evidence suggests that investment is affected by comparative advantage. Our low corporate tax rates, good labor market flexibility, skilled workforce, financial expertise, and world-class universities are some of the factors that, in aggregate, remain key to driving growth. Watch the UK’s low level of unemployment and good investment levels when compared to our EU neighbors – in fact, there have been years since Brexit when there has been more inward investment than Germany and France combined.
There is also a broader, longer-term tailwind for REITs. The debacle of major open-ended funds having to close their books to redemptions due to their size after the EU referendum has raised questions about whether their structure is best suited for such investments, given the timelines involved. Moreover, around £20 billion in this money was held up when redemptions were suspended again at the start of the pandemic in March 2020. The Consortium of Investment Firms (AIC) and Alan Brierley at Investec, among others, have been critical of its suitability. The Financial Conduct Authority (FCA) is looking at possible solutions, including proposing a 180-day waiting period before refunds are fulfilled.
The closed structure of mutual funds is more suitable for such long-term investments. It allows fund managers to invest without having to worry about holding high cash levels for potential short-term paybacks. It also allows for leverage, which has increased returns including income in emerging markets. No wonder the investment confidence sector has, in the long run, yielded much higher total returns, while providing investors with much higher dividend yields.
Looking to the future, judicious use of adjustment will again be needed to boost total returns – especially if more cautious estimates of future returns prove correct. Meanwhile, high cash levels within open funds will once again prove to be a drag on performance, especially when these balances are charged. For some investment houses, the writing is on the wall. Janus Henderson recently sold his fully open-end UK property fund of £1 billion to an undisclosed buyer – the fund’s size was halved after the redemptions when the moratorium was lifted. Others will likely follow suit. By comparison, REITs will look increasingly attractive over time — existing discounts bolster stronger fundamentals.
Of course, stock and segment selection, along with location, will remain major determinants of the extent of future returns. The latest figures for March put year-on-year rent growth close to 4 per cent – the largest increase since 2016. But the numbers mask wide disparities – office rents are up 1.1 per cent year-on-year, and industrial rents 11 per cent thanks to Continuing strong demand for logistics and warehousing services, the retail business posted its first modest month-on-month increase in four years. Overall, year-over-year capital values were up 18.2 percent, helping total returns to exceed 24 percent.
Similar returns were achieved in the summer of 2010, which were in turn the highest since 1994. The sector is advancing steadily after the pandemic – as evidenced by UK commercial property investment in March being the highest in a few years. Other anecdotal evidence suggests that demand remains strong. Janus Henderson’s wallet selling price details have been withheld, but it’s known to have been higher than the most recent valuation.
Portfolios continue to favor those companies that focus on industrial assets, given the logistical background and consumer trends helped by developments in technology. We also prefer well-located office assets despite the potential for increased flexibility in business practices. This is partly because returns of 7-8 percent are attractive and sentiment is very low, although a good choice is based on standard hiring and often through more attractive alternative uses of offices, particularly housing and/or industrial units. The vistas look particularly attractive outside the southeast. Other than that, some well-chosen retail assets look more interesting since there is a lot of bad news in the price.
The preferred holding in most portfolios of the 10 real managed mutual funds on the website www.johnbaronportfolios.co.uk is Standard Life Property Income (SLI) FundWith its well-managed and diversified exposure to the UK market, combined with a proven track record of outperformance. About 80 percent of the exposure is committed to industrial and office assets, with retail and other businesses making up the balance. Despite its cautious approach and a more favorable outlook overall, the company stands on an unforgivable discount of 24 percent at the time of writing, while offering a return of close to 5 percent.
Other purse collectibles include Regional REIT (RGL), which focuses on quality offices and good offices mostly outside the Southeast, where supply is scarce. The company has a proven track record under its seasoned management, and is poised to recover and witness the purchase of managers. However, it enjoys a discount of close to 15 percent while offering a return of 7.7 percent. Again, this is intolerant. Patience investors will be rewarded.
Another decade is TR Ownership (TRY), which invests in real estate stocks mostly on the continent, where sentiment is also weak, while owning a small portion of physical property in the UK. As such, their NAV tends to be more correlated with stock markets than REITs. It currently stands at a small discount while offering a return of close to 3.5 percent. Like SLI, the company’s track record is very good under its well-established and respected manager and team.
|January 1, 2009-30 April 2022|
|Standard (%) *||217.4||154.6|
|Since the beginning of the year (until 30 April)|
|Standard (%) *||-3.7||-4.3|
|* The MSCI PIMFA criteria for growth and income (total return) are cited.|