Commercial property on firm ground

By Bridging Loan Directory -

Property funds have delivered positive returns in a turbulent market and managers believe there will be growth into 2012, reports Cherry Reynard at Money Marketing.

Many investors would gladly have traded the prospect of higher returns for stability over the last few months. But stability of both income and capital values has been hard to find during the recent market volatility.

Commercial property has emerged as a surprise winner in this respect, with many direct property funds delivering positive returns during the equity market rout. Equally, a number of property managers believe that certain parts of the market will continue to deliver a stable income and even moderate growth into 2012 but as the economic environment weakens, investors need to be increa- singly selective.

The overall performance of the property sector is unexciting. The average fund has dropped by 6.8 per cent, which is better than all equity sectors except Japan but worse than, for example, the absolute return or sterling corporate bonds sectors.

However, this average hides a significant variance in underlying fund performance, with the majority of bricks and mortar property funds delivering a positive return for investors over the period. In contrast, property equity funds have been buffeted by the volatility in equity markets.

Royal London property fund manager Stephen Elliot says a number of factors have tended to characterise the better-performing funds over the last six months. In addition to a higher weighting to direct property, funds holding properties with long-dated income streams and fixed rental increases have performed better.

He says: “Location has also been a key factor. Rental levels and valuations have held their own in places that have an affluent pull on them such as the cathedral cities – Chichester, Winchester and Canterbury.” He adds that the London market has also been strong.

Managers say there has been a two-tier market, where prime assets with strong tenant security and long-term stable income flows have performed well and secondary property in weaker locations and exposed to less stable tenants has performed badly.

The majority of managers believe this situation is unlikely to change and that the current market environment is too volatile to take a risk on secondary assets.

Threadneedle head of commercial property Don Jordison says: “The two-tier nature of the commercial property market is unlikely to change any time soon. If anything, as banks seek to deal with the non-performing loans on their balance sheets, which make up a significant proportion of the debt on UK and Irish bank loan books, there is likely to be further downward pressure on the pricing of secondary property assets.”

Prime assets, in contrast, continue to enjoy a relatively supportive backdrop. Kames Capital investment director for UK and international property David Wise says that international investors like the strong rule of law in the UK and the transparency of its property market. These investors have supported the significant compression in yields that has been seen in super-prime property markets such as Bond Street in central London but have also supported other parts of the market.

Also, even though yields have come in for prime property, they are still relatively attractive.

Elliot says: “If the yield on property is the gilt rate, with some risk built in, there is still a reasonable amount of fat, even at the prime end of the market.”

He believes that prime property may even seen further capital growth from here and says. “In 2012, capital values are likely to be fairly flat overall. The price of prime property may get slightly higher and at the secondary end it may get a bit softer but it is likely to stay pretty stable barring a complete disaster in Europe.”

Ignis UK property fund manager George Shaw is also prioritising the prime end of the market. He believes that demand for prime assets will flatter overall growth figures in the commercial property market is predicting a total return of 8.7 per cent for 2011, higher that the Investment Property Forum consensus of 7.4 per cent and the Property Market Analysis consensus of 6.7 per cent.

But some managers are dipping a toe outside prime property. Wise says: “We are starting to see some attractively priced deals in the secondary market. Of course, you need to be extremely careful. These deals are not specific to one sector and managers have to look at stock-specific characteristics rather than making large asset allocation calls.”

He has negotiated a number of good deals outside London, which he believes can generate strong returns.

He adds: “Anything outside London is more of a challenge but I am a stock-picker and I like to dig around in situations where there are not lots of other buyers. This is the way to pick up alpha in these markets”

There are still unquestionably toxic areas in the market. For example, managers point to some Northern high streets, with up to 30 per cent vacancy rates. This means that landlords cannot replace tenants that go bust or consolidate.

Shaw says: “The areas of most concern are regional offices and standard retail property outside the top 20 major locations in the UK. Individual stocks all need to be located and well configured. It does not necessarily have to be in London and the South-east but these have been the areas of economic strength.”

There have also been toxic areas outside the UK. Although a number of the specialist Asian property funds have done well in recent markets, many of the global property funds have performed poorly. As might be expected, those with a European bias have been particularly weak. The Swip European real estate and Huet Capital European residential property funds have shown double-digit falls over the last three months. Discounts to net asset value have moved out on property shares and Reits generally.

The property sector does offer investors some stability but it is not without its pitfalls. Its stability has partly come from the fact that it is protected against some of the worst excesses of sentiment but this only applies to bricks and mortar property while property equities have been blown around with the wider market volatility.

Wise concludes: “Property has been viewed more attractively in the last three months. It does not have the volatility characteristics of the equity market. It is paying a yield of 6-7 per cent and a manager does not need to be doing too much or taking too much risk to get a decent long-term return.”

(c) 2011 Money Marketing. All rights Reserved.