Will Fulton and Jamie Horton, Investment Managers, UK Commercial Property REIT
Interest rates have dented commercial property valuations over the past 18 months
Three elements are crucial to the outlook for the commercial property sector: revaluation, investment recovery and a supply squeeze
There are still vulnerable parts of the market, particularly in the office market
Commercial property has faced two major challenges over the past 18 months. Rising interest rates led to the fastest revaluation of commercial property assets recorded, with reductions particularly felt at the lower yielding end of the market. At the same time economic conditions have meant occupier demand in certain segments of the market has remained unpredictable or weakened. While it has unquestionably been a turbulent period, there are reasons to believe the cycle may be turning for high quality commercial property from here.
We identify three key elements that are crucial to understanding the outlook for the commercial property sector: revaluation, investment recovery and a supply squeeze. Our view is that the revaluation of the property market is largely behind us with the exception of the office sector which is facing structural challenges. While calling a peak in interest rates is a challenge that even the Bank of England shies away from, our central expectation is that interest rates will rise once or twice more before starting to fall next year. Inflationary pressures have weakened, and the Bank of England has made it clear that further rate rises will be data-dependent.
For the industrial sector, where operational performance is still strong, this suggests that asset values should recover albeit they are unlikely to achieve the extremely low yields witnessed in late 2021 / early 2022. However, there are still vulnerable parts of the market, where valuations could dip lower. We see this particularly in the office market, where landlords face the combined challenge of reduced occupier demand as a result of post-Covid working habits and an increase in costs to provide the amenity and ESG credential tenants require.
Investment recovery will depend on a revival in the economy and the UK is unlikely to recover significantly until interest rates start to drop. The interest rate cycle has had a more significant impact on commercial property markets in this cycle compared to previous cycles as it followed a long period of historically low rates followed by sharp increases. If interest rates start to drop next year, there is a case for an investment recovery led initially by rate cutting and thereafter economic growth. Again, we believe the higher quality sectors with structural growth potential will be the early beneficiaries.
We have also identified an imminent supply squeeze in certain segments of the commercial property market such as industrials as development has been constrained by rising build costs, increased finance rates and weakening yields. We therefore still see potential for strong rental growth in the industrial sector and in alternatives, and this is where we are focusing our attention for the portfolio. There isn’t enough space, particularly in the right spots, to meet demand.
How we are handling it
While the outlook is improving, until the interest rate cycle has clearly turned there is still uncertainty. UKCM continues to focus on high-quality assets, with strong operational characteristics to maintain resilience into the portfolio. This is shown in our occupancy and rent collection statistics – 99% and 96% respectively.
We continue to refine our portfolio to ensure that every asset meets our investment criteria and we have prioritised balance sheet discipline while debt costs remain elevated. This year, it has seen us sell a very low-yielding prime distribution warehouse, Hannah Close in Wembley. Existing lease agreements meant that low yield was constrained and it wasn’t possible to realise the full underlying rental value until 2029. We had also completed our full asset management plan on the property, leaving less upside to its valuation and used the proceeds to reduce the amount drawn on our revolving credit facility by 71%. While our overall debt costs are low, the cost of this facility which is now only 12% of our total borrowings has risen.
We have made great progress on our development programme completing three properties across the industrial and student hosing sectors. Our last remaining development is the Hyatt-branded hotel in Leeds’ Sovereign Square. As well as a fantastic location in thriving Leeds and a great brand in Hyatt, it has strong ESG credentials, an increasingly important factor in the hotel market. Construction continues at pace, and on completion the hotel will deliver a yield of 7.25% with the hotel opening early Q3 2024.
At a time of higher inflation, being able to push through rental increases is vital and a key advantage for commercial property over fixed income investments. Rental uplifts across the portfolio have generally been encouraging as we seek to capture the reversion within the portfolio we own through careful asset management.
Nevertheless, the economic picture is still fragile and certain sectors still look vulnerable. As a result our portfolio is well-diversified by sector, geography and with a mix of 193 tenants. We remain judicious in our focus on quality assets and also in our tenant selection and mindful of how the economic climate might change.
The Company’s dividend yield of 6.6% compares favourably to the higher quality end of the fixed income market, while also giving the potential for income growth. This puts us in a good position should the interest rate cycle start to turn next year.
Companies selected for illustrative purposes only to demonstrate the investment management style described herein, and not as an investment recommendation or indication of performance.
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Past performance is not a guide to future results.
Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
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Other important information:
Issued by abrdn Investments Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG. abrdn Investments Limited, registered in Scotland (No. 108419), 10 Queen’s Terrace, Aberdeen AB10 1XL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK.