There are many reasons for investing in commercial property, but not as many as there used to be, after the global crash triggered by the collapse of credit demonstrated just how much of a role leverage had been playing in generating returns.
Many property funds, both listed and open-ended, endured significant problems from having too much gearing at a time of falling asset prices. Such funds struggled to meet the demand for redemptions from investors.
So, almost six years after the event, do listed property funds offer value?
It is hard to declare that commercial property offers significant potential for capital gains, for at least the next few years. Most readers will know about the bifurcated nature of the UK property market. In London – and more specifically the City and West End – the property sector is in robust health. Demand for well-leased, prime-quality properties in the capital from overseas investors has forced yields down to very low levels.
Domestic investors who are fearful of sustained high levels of inflation may be willing to buy good-quality but possibly overpriced property assets, comfortable that low rental yields are a small price to pay for owning a well-let real asset in a low-growth environment.
Outside London, the situation is very different. Fund groups we have spoken to report a UK property market that is moribund, with little income or capital growth potential. The prolonged economic downturn has meant there are few discernable, positive news stories around the country; growth is limited to very specific areas, or even individual streets in certain towns and cities.
Graph 1 (on page 36) shows that after periods of boom and subsequent declines in value, it is usual to see a number of years of disappointingly low returns until the emergence of the next property cycle.
Bank finance evaporates
Clearly, one of the big causes of this situation is the increasing absence of the UK banks from lending to property investors. The large, now state-owned institutions are lending far less to asset-backed investments such as property. They have been forced to change their approach to lending by the need to shrink their over-leveraged balance sheet by both the UK Government as well as the Basel III legislation.
It is interesting to note the intention of London and Stamford and Metric Property to merge. The merger announcement declared: “Organisations across the world are deleveraging and we believe that this will continue to bring attractively priced assets to the market.” Scale is increasingly important in the property investment world.
For investors in open-ended property funds, investing can be tricky. Many are forced to hold significant cash levels to be able to meet redemptions. Given the absence of high levels of transactions in the sector and capital growth that is flat at best, the sector’s returns have been limited to the passing rent the funds can generate. Active asset management is helpful but only at the margin.
In the listed world, the situation is little different. The existence of permanent capital makes life easier for the fund manager to invest and indeed gear their funds without being too concerned about meeting ongoing redemptions.
Big is best
We think there are two ways of earning a meaningful return from listed property funds today. The first is to buy the biggest, best, most sensibly managed funds in the sector. F&C Commercial Property and UK Commercial Property are two of the largest, liquid investment companies, the latter run by Ignis.
These are probably the most core property funds available to investors, but they have their challenges. F&C Commercial is the better performer over recent years, its positive call on London and in particular the West End being a good one to date. UK Commercial Property’s more value-based decision to purchase a series of shopping centres in Shrewsbury has proved poor since it was made, hit by the economic slowdown and little price appreciation in the sector outside London.
Much of the sector is over-distributing to investors, paying between 10% and 20% of their annual dividends out of capital. This is less of a problem when an asset class is appreciating, but in a world of low capital growth it eats into potential future returns.
The funds run by F&C and Ignis are no different, and in reality should probably consider whether to rebase their dividends to a more sustainable level. However, boards of directors and shareholders are loath to sanction such an outcome given that retail shareholders dominate both funds.
The other way, we believe, is by owning the smaller, more turnaround stories in the sector. The best-performing UK property fund in 2012 has been Schroder Real Estate. Formerly known as Invista Foundation Property, the fund had a very disappointing track record since inception until 2011. As with many other funds, the potent cocktail of too much gearing within a fund that invested in generally non-prime UK commercial property saw its net asset value (NAV), dividend and share price all fall sharply between 2007 and 2011.
Schroder turns it round
Only after the fund’s management contract was moved to Schroder in 2011 did matters improve. Although it was still run by the same management team, lower management fees and a more stable and supportive parent saw the fund adopt a realisation strategy towards its better assets. This allowed it to generate real cash, pay down its debt and generally boost sentiment towards what appears to be a real improvement in the fund during 2012.
The fund is looking to refinance its debt packages over the next 12 to 24 months, which clearly presents a challenge to many property investors. In the meantime, investors receive a 9% dividend yield – as with most of the fund’s peers, this is uncovered by income generation – and a share price at a 20% discount to its NAV. If the fund can achieve sensible pricing and terms for the debt refinancing, we think it could evolve into a more core holding over time.
Finally, and given the withdrawal of banks from the sector, a new opportunity has emerged. There are, at the time of writing, two prospective fund launches that are looking to raise money to help finance commercial property purchases.
These funds will lend money to those buying property, and receive an attractive rate of interest and protective covenants for doing so.
This form of asset-backed lending offers little by way of NAV or dividend growth but does provide prospective dividend yields of around 6-7%. Given the illiquidity of the asset – each loan is individually agreed and unlikely to be traded – it is uncertain how these funds could address a widening discount should it occur.
A loan does rank as senior to equity in the purchase of a property, however, and so offers a degree of protection if the borrower or asset ends up in trouble or even defaults on its commitments.
Given the consensus view of little to no asset price growth, with positive returns coming only from income, these types of vehicle may become an increasingly popular alternative to traditional property funds in the coming years.