The polarisation in the valuations of prime and secondary property assets has continued to dominate the returns of property funds in the past few years.
Central London safe havens and primary assets outside of these remain in vogue while secondary assets have been repeatedly discounted by valuation agents, increasing their yields.
Overseas investors have continued to focus on prime London properties which have been delivering robust rental growth, buoyed by their limited supply – an area that is challenging for retail property funds to get sufficient exposure to given the hefty price tags attached.
This pattern does not surprise us. As authorities around the globe have used aggressive monetary policy to boost their struggling economies, investors have found difficulty in generating income from traditional sources.
With a near 6.5 per cent yield (according to CBRE) and record yield gaps relative to bonds and cash, property has been attractive for income-starved institutions.
Indeed, relatively weak economic data and financial repression have kept government bond yields at low levels and below headline and expected future inflation rates, suggesting medium-term returns could well be negative. Although investment-grade corporates offer better value, yields are also at all-time lows.
However, one must tread cautiously and investors should remember that yield is not income. The yield is the income distribution as a proportion of the capital value. If we compare the 6.5 per cent yield on property with a 10-year BBB bond that is now yielding roughly 4 per cent, the spread illustrates a compelling case for property.
Nevertheless, this attractiveness is somewhat diminished by falling capital values. Indeed, the decline in UK commercial property capital values continued to gather pace this year, with the three main UK commercial property sectors continuing to decline; namely the retail, offices and industrial sectors. Reassuringly, this pattern is expected to reverse during the course of the year, with investment houses forecasting a low single-digit increase in capital values in the next 12 months.
For investors seeking property exposure, there are some solid UK property funds available. We closely monitor a number of these, including M&G Property Portfolio, which we consider to be a high-quality proposition. The Threadneedle UK Property Trust, which focuses on higher-yielding assets often just outside the prime real estate category, is also highly rated as is the Legal & General UK Property fund.
Investors should note, however, that on average, direct UK property funds have struggled to outperform the IPD UK All Property index through time. The reasons are twofold. As the IPD index continues to rise, substantial cash holdings in funds – necessary to fund outflows, acquisitions and developments where applicable – have remained a drag on returns in the environment of very low interest rates in the UK.
Also, the index does not account for any fees or transaction costs, and these act as an additional obstacle to fund returns.
Real estate investment trusts (Reits), on the other hand, have been an appealing place to be, with UK Reits returning approximately 30 per cent last year.
Muna Abu-Habsa is a fund analyst at Morningstar OBSR
