UK retail investors holding property funds need to look carefully at their sector exposure to avoid significant drawdowns over the next 18 months, according to Cohen & Steers’ Rogier Quirijns (pictured). 
The senior vice president, who is also lead manager of the firm’s European Real Estate Securities fund and co-manager of its Global Real Estate Securities fund, warns that offices, retail outlets and central London housing will all be bruised by weak sterling and rising inflation as we head through 2017.
As such, he has reduced his UK office weighting from 15 per cent to virtually zero and has sold out of UK retail almost completely, opting instead for industrial Reits, student housing and self-storage buildings.
“Even before Brexit, we were concerned about the London office market as the office cycle has been going up for more than six years now. Generally speaking, office cycles are six years up and three years down,” Quirijns explained.
“In terms of supply coming to the market for 2017, we definitely saw more supply coming through, so we sold all of our office exposure at the beginning of last year. On top of that, Brexit came and that is clearly another negative, especially for offices.”
The fund manager warns that the strong devaluation of sterling and the fact we will undergo a ‘hard Brexit’ will also deal an extra blow to the retail market, which he says is already facing difficulties as a result of the rise of e-commerce.
If sterling remains weak and continues to fall, he says consumer spending power will continue worsening as inflation in the UK rises.
Performance of indices over 1yr
Source: FE Analytics
While Quirijns is cautious on the outlook for UK property generally, he still retains exposure to some areas of the market and has rotated out of the aforementioned sectors into income-focused Reits for increased portfolio protection.
“On a sector basis, we like UK industrials and logistics which have a certain tailwind from e-commerce,” he said.
“We also like student housing, because the pound has devalued and it’s one of the bigger export products of the UK and, overnight, it has become 20 per cent less expensive. It is still expensive, but people are willing to pay because of the quality of UK universities.
“We still like self-storage, it’s income-focused, occupancies are around 80 per cent so there’s still huge growth in that sector. It is generally a more secular trend and, given the house prices in London, people are always short of space.”
The manager dislikes the London housing market for this reason and believes that, while it has already started correcting, it has much further to fall.
Another alternative in the UK property space that he likes is healthcare, given that it benefits from the aging population, offers favourable income generation and is index-linked and therefore protected from a potential inflation spike.
“That’s the UK. It is a very interesting market and we sold a number of Reits during Brexit,” he continued.
“Instead, why not invest in the rest of Europe? Why not invest in continental prime retail centres instead of UK retail? In continental Europe, you aren’t going to have the headwind of inflation.
“Or, invest in German residential or German offices, or Spanish offices. Offices that could well benefit from Brexit. That is something that some retail investors aren’t aware of, I think they’re too focused on their own country and there is the perception they’re investing in something very stable which, ultimately, I don’t think is true.”
Shortly after the EU referendum result was announced at the end of June, a number of large open-ended UK property funds from houses such as Henderson, M&G and Threadneedle all suspended trading to safeguard investors from mass outflows.
Performance of funds in 2016
Source: FE Analytics
While all of these have since reopened, Quirijns warns that these funds are likely to encounter much greater headwinds as we head through the year.
“It’s a deterioration. At first it was sentiment with Brexit where investors tried but couldn’t take out their money, which was already bad. But what happens if, fundamentally, those funds have the wrong assets, or they’re not as diversified as investors think?” he said.
“Ultimately, I have hardly any retail exposure. These investors can’t overnight say, after the pound depreciated, question how this would impact the retail market and sell their exposure.
“Maybe they would sell out of their holding and invest in something else if they were able to, whether it’s property or not. I don’t think those investors have a good diversification choice at all.”
The senior vice president says the UK property market also isn’t pricing in a hard Brexit, especially when it comes to offices.
For instance, he says the likelihood of large international companies moving their employees out of London has increased significantly, which would see the demand for UK office space plummet.
As such, and given the resulting increase in office supply as these companies move out, he believes office rent needs to fall by between 15 and 30 per cent to justify current valuations.
“What happens if interest rates go up? Generally, global growth is picking up and inflation is picking up. So even if the UK does rather well, which we don’t expect it to but let’s say we’re wrong, it means interest rates go up and yields in the office market are still very low,” Quirijns explained.
“You have yields of sub 4 per cent in the West End, so if rates go up you can argue that yields need to move out too. And, at the same time, your rent is going down so that’s a toxic mix for real estate.
“That is one that we don’t think is priced in. The second one is retail and that’s somewhere I think that retail investors should be really cautious. The listed companies generally have the best assets and these companies already face difficult times.
“What does that mean for the retail parks? It means the ones that are owned by open-ended funds, in my view, have bigger problems. Are retail investors aware of that? I doubt it.”
He describes this difficult investing environment as the “canary in the coalmine” for investors in open-ended property funds. As such, the senior vice president urges investors to look under the bonnet of their PAIF exposure to understand where their income and capital growth is coming from.
“At first, the outflows were based purely on sentiment. Now, the fundamentals will catch up and that will happen slowly,” Quirijns said.
“Ultimately, the news on offices will become more negative and remain negative, so people will start to take their money out of these funds.
“Open-ended funds also have to hold a lot of cash for liquidity purposes, which people pay for. The cash levels are ridiculous.
“If I invest in a fund I want to know what I’m paying for and, in this instance, I would be paying these people to hold cash. My returns would also be significantly lower [compared to a listed securities property fund]. You end up with a huge cash drag, which is horrendous.”
Over the last five years, the four crown-rated Cohen & Steers European Real Estate Securities fund has returned 101.51 per cent, comfortably tripling the return of its average peer.
Performance of fund vs sector over 5yrs
Source: FE Analytics
The SICAV has a class A management fee of 1.4 per cent and yields 3.2 per cent.