Real estate is an ideal asset class in the low-rate environment, according to BMO Global Asset Management’s Marcus Phayre-Mudge, who runs the TR Property investment trust, adding that liquidity and income are best delivered through a combination of real estate and real estate equities. 
He said real estate has characteristics of both equities and fixed income. Indeed, one of the beneficial features of real estate is its ability to produce relatively consistent total returns that are a hybrid of income and capital growth.
“Real estate is a pro-cyclical asset class, behaving much like an equity; but historically, it has provided high and secure income,” he said.
Bonds are often thought of as less risky than other asset classes, but the safer the bond, the lower the potential rate of return.
One thing that makes real estate a better investment than bonds, the portfolio manager explained, is rental growth.
Bonds pay a fixed rate of interest during their lifespan, but inflation can cut into returns over time and reduce real gains.
So, while the value of the bond is static, real estate can increase in value through time.
Phayre-Mudge (pictured) said there are two reasons that make real estate attractive now: fundamentals and valuation.
On the level of fundamentals, tenant demands are improving (with the notable exception of the retail sector) and there is a lack of supply of space.
From the valuation standpoint, there’s earnings growth, debt cost increases are muted, and property shares often trade below net asset value (NAV).
“On fundamentals, we look for two key characteristics: one, is the yield comparison, to ensure that we’re receiving a significant margin over fixed income. This is to compensate for things like depreciation, obsolescence, and trading costs.”
He said a comparison of the yield of BBB-rated (investment grade) bonds and the dividend yield of the listed real estate companies within the FTSE EPRA Nareit Developed Europe index shows that real estate dividend yields are not only superior but also rising.
The reason for this, he said, is the rental growth found in many European markets. “London is the single European capital city where rents are flat,” he said. “In every other large European capital city, rents are rising.
Across the board, he added, there’s lack of supply or rental space. However, the other capital cities have more demand than London does at this time.
Phayre-Mudge singled out retail as the part of the real estate market, especially in the UK where rents have been expensive for a long time.
“The problem here is a double tsunami of, one, a secular shift to online shopping, which has been sucking the demand for physical shops,” said the TR Property manager.
He said the situation is better in the rest of Europe where lease terms are shorter, and rents are index-linked. So, retailers “don’t get trapped in these five-year upward rent review cycles you have in the UK,” he said.
However, he went on, the online threat in Europe is merely lagging behind that in the UK. “Online sales make up 20 per cent of all sales in the UK, ex food and fuel. It’s a little over 2 per cent in Italy at the moment.”
Nonetheless, the online phenomenon remains a growing threat in Europe as well, he said, even though “the earnings there are underpinned for a lot longer.”
But the stock market has already repressed a lot of European shopping centre share prices, he added, citing as examples, Unibail-Rodamco-Westfield that has gone from €250 per share to €141, and Eurocommercial that went from €45 to €25.
Phayre-Mudge is also concerned about UK residential real estate. “That’s because of the level of indebtedness of the UK consumer. We don’t see house prices moving upwards,” he said, noting that in the London market, there’s a huge amount of over-construction, “a risk area to be avoided for the moment.”
Since the early 1980s, income returns for unlevered commercial real estate has been consistently positive. The capital account, however, has experienced two periods of dramatic decline, which the fund manager terms “party hangovers”.
The first of these negative capital returns occurred between 1990 and 1993, and “was the consequence of over-construction, overexuberance of the 1980s that led to an oversupply. For a mature economy the UK’s, that took a long time to absorb, causing rents to fall significantly. This, of course, led to negative capital returns.”
The second period of capital decline was during the great financial crisis, and was caused by “too much money in the wrong hands at the wrong time.”
Encouragingly, Phayre-Mudge said, neither of those conditions, depicted in the graph below, is present in the current environment. So, “with the exception of retail, I’m very favourable about conditions in all other markets,” he said.
He said a common myth among many investors is that “real estate is a bit of a backwater, never really a top performer.” The reality is that this asset class has been a top performer on many occasions, he said.
“And most importantly, over the last 14 years, real estate has only been in the bottom quartile a couple of times. What drives this, and what’s absolutely crucial today, is income,” the manager concluded.
Phayre-Mudge has overseen the TR Property investment trust since October 2004, during which time it has made a total return of 493.71 per cent against a 449.33 per cent gain for the average IT Property Securities peer.
Performance of trust vs sector under manager
Source: FE Analytics
The trust is 10 per cent geared, is currently trading at a discount of 3.4 per cent to NAV, has a yield of 3 per cent and ongoing charges of 1.57 per cent, according to figures from the Association of Investment Companies.