Following a tough period during and after the financial crisis, investors have been well-rewarded for holding UK commercial property funds over recent years as not only has the UK economy been in recovery mode, but with ultra-low interest rates forcing bond yields to very low levels, the income potential of ‘bricks and mortar’ funds has drawn in huge inflows.
However, though most commercial property funds delivered double-digit returns last year while other asset classes struggled, Rees – head of real estate at Coutts – is expecting them to continue to perform well again this year.
“In a world of rock bottom interest rates, the high yields of UK commercial property have captured the attention of income-starved investors,” Rees said. “But with initial yields – annualised rents expressed as a percentage of property value – now below 5.5 per cent and possibly falling further, has the asset class had its day in the sun?”
“We remain positive on UK commercial property – though it might be more realistic to expect rental growth to play a bigger part then initial yields in determining total returns. And asset selection will be even more important in 2015.”
According to FE Analytics, an equally weighted portfolio of all the UK commercial property funds in the IA universe has returned 24.31 per cent since January 2013, beating the FTSE All Share and Barclays Sterling Gilts index which have returned 22.23 per cent and 9.81 per cent respectively over that time.
Performance of fund composite portfolio versus index since January 2013
Source: FE Analytics
Commercial property funds had a phenomenal last year, as the graph above shows, gaining 14 per cent while the UK equity market ended the year flat. While gilts returned slightly more, property funds – due to the nature of the asset class – delivered smoother performance.
However, following that performance, the average yield on commercial property funds has dropped from 4.3 per cent to 3.8 per cent over the past 12 months.
Investors can find higher levels of yield within the closed-ended space. However, the average direct commercial property investment trust is trading close to a 10 per cent premium to NAV – reflecting the huge demand for income-producing assets.
Investment trusts’ yields and premiums
Source: FE Analytics
Nevertheless, Coutts says this trend of falling yields is likely to continue.
“History suggests that we’re not far off the bottom of the yield cycle for commercial property,” Rees explained.
“Yet in an unprecedented era of prolonged low interest rates – with the UK base rate unlikely to rise until 2016, at the earliest, in our view – the paucity of alternatives mean investors in search of yield are likely to consider commercial real estate assets.”
“Against such a backdrop, who can say that initial yields won’t slide lower still?
Another contributing factor as to why yields on commercial property funds have fallen is due to the amount they have to hold in more liquid assets in recent times. But this has put some investors off the sector.
Following some dire situations in 2007/2008 when investors were effectively locked into open-ended property funds as groups couldn’t deal with outflows, managers within the space have kept a keen eye on liquidity levels within their portfolios in recent years.
However, as so much money flew into commercial property funds last year, cash weightings have risen to very high levels as managers
couldn’t invest their capital quickly enough, given the illiquid nature of the asset class.In an article last year, Charles Stanley’s Rob Morgan warned investors about this phenomenon and said he was avoiding the sector as while investors may be buying property funds, they weren’t getting a huge amount of exposure to actual commercial property.
“I think a big issue at the moment is that so much money has probably gone into property funds – i.e. physical commercial property – and many have elevated cash levels, which obviously dilutes future performance – and yield, which is probably why people bought them in the first place,” Morgan (pictured) said.
When the article was written in November 2014, out of the £15bn in the 10 largest property funds, £3bn wasn’t invested in property.
Source: FE Analytics *as of 23/11/2014
Today, the average IA UK direct commercial property fund has 81.37 per cent exposure to UK direct commercial property, according to FE Analytics with the likes of SJP Property holding 25 per cent in other asset classes.
Nevertheless, Rees says there are a number of reasons why investors can afford to hold property within their portfolios as while yields may play less of a role in determining total returns, rental growth will become an increasingly important factor.
“As economic growth in the UK spreads – underpinned by rising wage growth – we expect to see prime office rents rise across regional city centers this year,” Rees said.
“Overall, prime headline rents in Manchester are expected to reach record highs of £34 per square foot by the end of 2015 – a 10 per cent increase over the year. Meanwhile, analysts predict office rental prices will inflate by more than 5 per cent in Bristol in 2015, getting closer to a £30 per square foot threshold, with prices driven up by limited supply. Indeed, in our view, a lack of supply at the prime end of the market will add further upward pressure on rental growth.”
He added: “And unlike residential property leases, commercial property has traditionally contained clauses dictating that rent reviews are ‘upward only’ or at least linked to an inflation index.”