Central London has been the leading light of both the UK’s residential and commercial property markets since the period after the financial crash. While the rest of the economy has been struggling through a recession and subsequent anaemic growth, the price of commercial property in central London has soared due to the capital’s status and its attractiveness to foreign investors.
However Rowley, who manages the £2.36bn M&G Property Portfolio, is concerned that valuations have gone too far.
“We call it the London conundrum,” Rowley said. “There is no doubt that we have had four years of very good performance out of central London.”
“Yes, London is still the key gateway to overseas capital as foreign investors love the fact if they buy a property here they know they are going to be able to keep it.”
However, while the manager says there are still many reasons to invest in commercial property in central London, such as its attractiveness to foreign investors and the lack of new supply in prime locations, there are more reasons to steer clear.
“It is the only part of the UK market where yields have been driven down to well below their historic averages,” she said.
“Also, through 2012 and 2013, it has been very difficult to get any bank debt outside of central London, but as a normalisation in bank lending is anticipated, then it will become a lot easier,” Rowley added. “That will put downward pressure on central London.”
“Another point is that the future returns from London property are very dependent on high rental growth expectations, so if it doesn’t come through as expected, it will mean the area will struggle,” she added.
Due to her concerns about the capital’s lofty valuations, she is beginning to shift her positioning within the M&G Property Portfolio.
For example, she has been upping her south east and regional exposure (by the latter she means the “big six” of Bristol, Birmingham, Manchester, Leeds, Edinburgh and Glasgow), with one of her most recent acquisitions being a shopping centre in Sutton Coldfield.
Rowley currently only holds 2.8 per cent of the fund in the central London area. Our data shows that the south east and the Midlands are her largest regional positions, while the rest of the fund is split relatively evenly between the south west, the north and Scotland, with further minimal exposure to Wales and Northern Ireland.
“We are now underweight central London offices and overweight the rest of the UK offices, as I am positioning the fund where I want it to be,” she said.
Rowley’s M&G Property Portfolio was launched in its current form in June 2009.
It has returned 28.01 per cent since then, meaning it has underperformed against the IMA Property sector. However, it is important to note that M&G Property Portfolio invests in direct property, while the majority of funds in the sector invest in property shares.
Performance of fund vs sector since June 2009
Source: FE Analytics
The major reason why Rowley is happy to spread her fund's exposure outside of London is because she says the UK economy is beginning to improve, which is good news for the commercial property market.
“The health of the market is closely linked to GDP. I think the UK economy will continue to improve as we have seen continual upgrades to GDP expectations recently,” she said.
The manager says that, given the ultra-low interest rate environment and the expectation that the majority of bond-holders will be hit by capital losses as gilt yields continue to rise, income-hungry investors can afford to take more risk and dip into the UK’s secondary market.
“There was more momentum in the market in 2013, with the strongest of that momentum outside of central London,” Rowley said.
“We are at a tipping point: I think the secondary market will start to outperform prime in 2014, having seen prime outperform for the last three years.”
One of the reasons why the secondary market offers better value, according to Rowley, is because the yield gap between the primary and secondary market had stabilised at a high level and is now beginning to contract.
She also points to the fact that transaction volumes in the UK have been improving as better sentiment has been driving increased investment activity.
While central London has tended to be the major provider to the UK’s total transaction activity, its contribution started to wane in 2013.
“We are seeing more transaction activity permeating out of central London into the south east and the regions and there is now a reasonable yield arbitrage between regional and central London,” she added.
Property, as an asset class, has become more popular over the past year. Data from FE Analytics shows that the IPD Property Index of UK property prices has only just climbed back above its pre-crisis peak, and is now 0.49 per cent above that 2007 high.
Performance of index over 7yrs
Source: FE Analytics
However, one of the major contributing factors to this is that cautious investors are having to move out of cash and bonds to find a decent, and less risky, level of yield.
When asked if the recent good performance of UK commercial property was because of real demand or the weight of money coming into the market from other asset classes, she answered: “When we look at yields and whether the market is cheap or expensive, the only market that is in expensive territory is central London.”
“Prime is still good value, while secondary is cheap. However, it is something we look at closely as we do have a weight of money coming into the market.”
Rowley says it cannot be assured that the property market won’t overheat as investors are forced out of traditional fixed income assets such as gilts and cash. She says investors need to be careful and it is something she is keeping a close eye on.
“Watch this space,” she said. “We will have to see what happens. It will be telling if the market is caught by a weight of money as it will turn more cyclical. It is a risk that is out there,” she added.
The M&G Property Portfolio has an ongoing charges figure (OCF) of 1.8 per cent and requires a minimum investment of £500.
It currently yields 2.93 per cent.
