Last month’s article (“Shifting dials”, IC, April 24) highlighted that the dial is shifting on a range of issues and how that is contributing to one of the most challenging investment environments in decades. decades. Appropriate portfolio diversification relative to mission and risk profile is now more important than ever. This should include adequate protection against rising inflation. Commercial real estate helps with diversification, but sentiment is weak. Still, the sector’s fundamentals are a little better than generally recognized, while it generally does well over time during periods of inflation. As such, deep discounts and high yields again present an attractive opportunity for the patient investor.
The sector was particularly affected by the financial crisis of 2008-09. This exposed companies with large borrowings, interest costs and development exposure. The market was ruthless and nearly blind, and significant stock price declines were seen. In the years that followed, companies got their house in order to the point that most are now more resilient.
Debt levels are low and existing debt has been secured at very low prices in recent years – with very few companies with medium-term refinancing needs. A notable feature of this real estate cycle has been the lack of investment and therefore the shortage of supply. Meanwhile, thanks to the crisis, managers have been much more cautious – there is a lack of development exposure, a focus on income, which has ensured that dividends are generally covered, and diversification between sectors and regions. Good management of assets and finances helped the cause.
As such, the sector weathered the storm of the door being rushed by mistake and the closure of a number of open-end commercial property funds immediately after the Brexit referendum result – which remains a talking point for investors and a priority for the Financial Conduct Authority (FCA). However, the pandemic has proven more difficult. Businesses and tenants struggled, rent collection rates fell, dividends were cut and rebates widened. Sentiment only partially recovered and this was not helped by economic uncertainty and expectations of rising interest rates.
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The sector is not homogeneous. Real estate investment trusts (REITs) tend to focus on income, while development companies lean more toward capital appreciation. There are also a variety of sub-sectors. It is an asset class with different characteristics from others, such as bonds, renewable energies, infrastructures or commodities. But it shares a common trait 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 companies and renewable energy.
Recent research suggests that UK sector total returns beat inflation over the period from the end of World War II to the financial crisis. The composition of these returns has changed with inflation. During the first 20 or so years of low inflation and the period of falling inflation from 1981 to 2009, rental income provided the majority of these returns. However, capital growth took on greater importance during the period 1967-1981, when inflation was a problem. Looking forward, there is no indication that it will be any different this time around – capital growth should be on the rise again to help total returns outpace inflation over time.
Another concern for some industry skeptics is the impact of Brexit. This again turns out to be unfounded. Although economic uncertainty abounds globally, evidence suggests that investment is influenced 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 remain, overall, d key to generating growth. This is evidenced by the low unemployment rate and good levels of investment in the UK compared to our EU neighbors – indeed there have been years since Brexit when foreign investment has exceeded that of Germany and France together.
There are also broader long-term tailwinds for REITs. The debacle of large open-end funds having to close their books to redemptions due to their scale following the European referendum has called into question the suitability of their structure for such investments, given the timeframes involved. In addition, around £20bn was trapped in these funds when redemptions were suspended again at the start of the pandemic in March 2020. The Association of Investment Companies (AIC) and Investec’s Alan Brierley, among others , have long criticized their relevance. The FCA is exploring possible solutions, including the proposed 180-day waiting period before redemptions are satisfied.
The closed structure of investment trusts is much better suited to such long-term investments. It allows fund managers to invest without having to worry about keeping high cash for potential short-term redemptions. It also enables gearing, which has increased returns, including income in rising markets. It’s no wonder that, over the long term, the investment trust industry has produced much higher total returns, while offering investors a much higher dividend yield.
Going forward, the prudent use of leverage will again be necessary to improve total returns, especially if the more conservative estimates of future returns turn out to be correct. Meanwhile, high levels of liquidity in open-end funds will again prove a drag on performance, particularly when fees are charged on these balances. For some investment houses, the writing is on the wall. Janus Henderson recently sold his entire £1bn UK Property open-end fund to an undisclosed buyer – the fund having halved in size following redemptions when the suspensions were lifted. Others will probably follow. By comparison, Reits will look increasingly attractive over time – with stronger fundamentals bolstered by current discounts.
Of course, stock and sector selection, as well as location, will remain key determinants of the magnitude of future returns. Recent figures from March suggest year-on-year rent growth approached 4% – the biggest increase since 2016. But the figures mask wide variations – office rents rose 1.1% per year, industrial rents by 11% thanks to continued strong growth. demand for logistics and storage, and retail trade recorded its first modest monthly increase in four years. Overall, year-over-year capital value increased by 18.2%, driving total returns to over 24%.
Similar returns were achieved in the summer of 2010, which in turn were the highest since 1994. Uni in March was the highest in a few years. Other anecdotal evidence suggests demand remains robust. Details of the sale price of the Janus Henderson wallet were not disclosed, but it was known to be higher than the last valuation.
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The portfolios continue to favor companies that focus on industrial assets, given the logistics backdrop and consumer trends driven by technological advancements. We also favor well-positioned office assets despite the prospect of increased flexibility in working practices. This is partly because yields of 7-8% are attractive and sentiment is at an all-time low, despite good selection underpinned by record employment and often the more attractive alternative uses to which offices can be put. intended, in particular housing and/or industrial units. . Prospects look particularly attractive outside the southeast. Otherwise, some well-chosen retail assets now look more attractive given that most of the bad news lies in price.
The preferred position in most of the 10 managed real estate investment trust portfolios on the website www.johnbaronportfolios.co.uk is Standard Life Real Estate Income Trust (IRS), thanks to its well-managed and diversified exposure to the UK market, as well as its excellent track record of outperformance. Around 80% of the exposure is committed to industrial and office assets, with retail and other commercial making up the remainder. Despite its cautious approach and the more favorable outlook in general, the company is sticking to an uncharitable discount of 24% at the time of writing, while offering a yield close to 5%.
Other portfolio holdings include Regional REIT (RGL), which focuses on good quality and well-positioned offices, mainly outside the southeast, where supply is tight. The company has a strong track record under his experienced leadership, is on the verge of a turnaround and sees its directors buying. Still, it sits on a nearly 15% discount while offering a 7.7% yield. Again, this is not charitable. Patient investors will be rewarded.
Another operation is Property TR (TRY), which invests in property stocks primarily on the continent, where sentiment is also poor, while holding minimal physical assets in the UK. As such, its net asset value tends to be more correlated to stock markets than REITs. It is currently holding onto a small discount while offering a yield of almost 3.5%. Like SLI, the company’s track record is very good under the leadership of its long-established and respected director and team.
|January 1, 2009 – April 30, 2022|
|Year-to-date (until April 30)|
|*MSCI PIMFA Growth and Income benchmarks are quoted (total return)|