The problems experienced by property funds in 2016 were based on investor issues and not the fundamentals of the sector, according to Henderson UK Property PAIF manager Ainslie McLennan, who says her fund is better prepared for more potential uncertainty this year.
Shortly after the Brexit vote in June last year, property funds were in the spotlight as many of the top groups were forced to gate funds and sell asset to meet redemption requests following a surge in outflows from ‘bricks and mortar’ portfolios.
McLennan said: “The week after [the referendum result] some of the other funds in the peer group had to suspend and the result of that was some of the funds that were open were used as ATMs for people feeling panicky about liquidity in the property sector.”
As the below graph shows, inflows had already begun to drop off ahead of the UK referendum on EU membership with investors becoming nervous over the result.
Assets under management of IA Property funds prior to EU referendum
Source: FE Analytics
McLennan said: “All of that was an investor issue, so this was not a property issue. At a property level it was pretty much the story we expected it to be for 2016.”
At the end of 2015 and the beginning of 2016, consensus expectations were that capital growth was slowing and would eventually dry up with the sector reverting back to an income story.
“But that story was completely lost and I think people felt there was an issue in the property market,” the manager added.
Eventually, the Henderson UK Property PAIF fund was also forced to suspend, reopening 100 days later on 14 October 2016.
“Over that period we had the opportunity to raise liquidity quite considerably and we took the opportunity at the same time to really appreciate and look at what we wanted to hold over the next 24-36 months if there was going to be potential for more uncertainty,” she said.
Performance of Henderson UK Property PAIF in 2016
Source: FE Analytics
The first area the fund decided to sell out of was commercial property in London, which they identified as under pressure heading into the rest of the year and into 2017.
“When I see headlines that commercial property in the UK should have a negative return this year, I think if you were in portfolios that were heavily skewed to London offices that could very well be true,” McLennan said.
“If you look at the City, Midtown and West End returns over 2016/17 they are negative and there’s a lot more risk at that part of the market.”
She says one of the main reasons London commercial property is likely to struggle is the impact of the Brexit vote, with some companies threatening to move their offices abroad.
“I think the concern and feeling from those valuing property especially is that if any financial institutions do even brass plate to another jurisdiction that could impact quite quickly on occupational demand,” said McLennan.
As well as this the fund manager says rental markets were getting towards the top end of valuations and that the current business cycle was drawing to an end.
“It naturally has bigger spikes and troughs anyway in terms of its cycles and that’s a 'business as usual' situation. We saw rents getting to the top and they will probably go back into the next cycle at the end of this year or the beginning of 2018,” she said.
“The business rate hike which will have quite an impact on the term level for many occupiers in London that will have a big bearing on sentiment for London offices.”
As a result the fund sold £370m worth of London assets while suspended almost half the total amount of assets sold over the period.
McLennan said: “The first of those was [440] The Strand, a very large asset worth almost £200m in the fund and two-thirds of its income came from RBS in the form of Coutts UK HQ.
“A very big skew in a very large fund. However, our fund was shrinking and a £200m lot size can quite quickly move the performance dial positively if yields are coming in but if they’re not or there’s risk particularly for financial tenants of yields moving out that can strip out all the great growth we’ve had on that asset.”
However, having bought the asset for £175m less than two years previously, it was sold for £198m, a 13.1 per cent increase.
She adds that with the fund’s return forecast in the London office space set to be low, it was an “important asset to sell”.
The other asset sold was Ryder Court, a multi-let asset in Mayfair, which the fund has held since 2013.
The manager said: “[When] we bought the asset it came with rents of between £56-65 per square foot.”
“The team did a good job refurbishing floor-by-floor this asset which badly needed it and we topped out at Q3 last year around £105 per square foot – so you can see the growth was huge in terms of where the rents have moved on to.
“There was really nowhere else we could take the rents on that particular asset. It was the optimum time for us to sell that asset and we sold to an overseas investor.”
The sell-off of London assets “should really protect us in 2017 in terms of our positioning,” the fund manager said.
The other area the fund has sold out of is regional office space, with only one such building left in the £3.1bn portfolio.
“Occupation rates if there’s any uncertainty at all it can be quite difficult for re-letting with existing tenants and certainly difficult to push rents up if everyone is feeling a little bit uneasy about the economy.
“It's an area we stay very light to and in fact only have one regional office outside of the South East left within the portfolio.”
Other than these areas, she says the market looks okay, but she says the fund, which sold £800m worth of assets while suspended at a 2 per cent discount to pre-Brexit prices, remains committed to add liquidity in case investor sentiment drives large outflows as was seen in 2016.
The goal is to have 25 per cent liquidity, with investments in products such as Reits and cash.
“We are trying hard [to get] towards that and to get the best result we can, but we have got to have more liquidity than we have had historically as we have uncertainty with the triggering of Article 50,” she said.
For investors looking at the sector, she says the fundamentals remain the same and while capital gains are likely to be harder to come by, it remains a good play for income and diversification away from other assets such as equities and bonds.