PropertyMar 27 2014

Potential in property

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In addition, steady returns at a time when other asset classes are likely to experience periods of volatility, and a lack of correlation to other areas of the market, make commercial property an attractive investment diversifier.

The UK commercial property market is a well-established and mature asset class that attracts a broad range of investors. Property funds are a good way for retail investors to gain access to commercial real estate. This is because commercial properties are often valued in millions of pounds, placing them beyond the means of all but the very rich or institutional bodies like pension funds and insurance companies.

Pure bricks and mortar funds typically focus on holding a range of physical property assets used for commercial purposes across a number of sectors. These include high street retail units, department stores, shopping centres and retail parks, office buildings, industrial warehousing or leisure alternatives, such as hotels, cinemas, car show rooms or gyms.

At a time when yields on traditional income-bearing products, such as government bonds, remain low and cash deposit rates offer investors very little reward on their savings and are being eroded in value when the effects of inflation are taken into account, commercial property has the potential to provide an attractive and stable level of income.

Couple that with the fact that leases are often structured with upwards only rent reviews, or tied into movements in the retail prices index, investing in commercial property can help provide protection from the effects of inflation.

While a robust, growing income has been the main driver of commercial property returns over the long term, making it popular with income investors, the asset class also offers the potential for capital growth, should the underlying properties rise in value. Property pricing remains on the path to normalisation. Positive monthly capital value gains since May 2013 and signs of rental growth mirror the recovery taking place in the UK economy.

Peak

The wider market remains attractive versus the peak of 2007, particularly as the recovery is not uniform. The requirement for high-quality assets has driven down prime yields and led to demand growing for commercial property outside the southeast and also within the alternatives sector. Despite strong competition for assets, value remains in London and the southeast where occupier demand supports rental growth.

Unlike other asset classes, a property fund manager can utilise asset management strategies to enhance the income and capital returns from assets. This can include refurbishment work to improve valuations and attract a better quality of tenant, changing the planning use of assets to increase rental revenue, or re-negotiating existing leases to extend tenancies. Sustainability is a key consideration within a portfolio and it is important for a property fund manager to align their interests, as the landlord, with those of their tenants, through responsible property investment. This helps de-risk assets and prevent obsolescence.

Commercial property investing is not just about location. The quality of the buildings and the types of tenants they attract are also of paramount importance. Prime, high-quality buildings in good locations with great specifications are highly sought after by both occupiers and investors. This means they typically command attractive leases, which minimises the risk of obsolescence. Core assets have some of the credentials a prime property would have but not all of them. Secondary, lower-quality assets tend to attract less reliable tenants, which is extremely relevant in today’s market when much of the risk associated with a property fund is likely to be linked to occupiers. The long-term structure of leases on assets held within direct property funds - usually five years or more - may also help to provide investors with a source of relatively secure income, in comparison to other asset classes.

The UK occupier market remains mixed with certain areas still struggling, which is why a focus on tenant strength, location and sector is extremely important. It is essential to pay particular attention to the quality of tenants and the relationship with them because the rental income stream they provide is ultimately passed on to investors in the form of fund distributions.

In recognising that investors are seeking a steady and relatively secure income property fund managers need to look for low-risk tenants on long leases that have strong financial resources. This reduces the risk of tenant default and of having vacant properties, which would erode performance. On one unit trust the majority of the major tenants are drawn from large, established businesses such as B&Q, Centrica, and Tesco. Importantly, the weighted average lease length on the fund is 10.9 years and as a result of strong active management, negotiating with existing or new tenants in this instance, the fund’s occupancy rate stands at around 100 per cent.

Location is an important consideration with the prospects for different areas of the UK varying, potentially impacting the financial health of the underlying tenants. One fund manager retains a southeast bias in its fund because the managers believe economic growth is set to be strongest in this area. Opportunities, however, continue to be found across the rest of the UK with some attractive regional properties owned.

Investing in a property fund can be a simple and attractive proposition but it can provide its own challenges. For bricks and mortar-type property funds assets can take some time to sell, particularly in difficult market conditions. It is therefore important that a property fund has good liquidity, in terms of the quality of its portfolio, and sufficient available cash to be able to meet redemptions should investors wish to withdraw their money. Many of the leading property funds typically hold between 10 per cent and 20 per cent in cash, which provides a comfortable buffer should the need arise to cover investor outflows.

In summary, commercial property funds, particularly those owning a greater proportion of higher quality property assets, should appeal to investors on three fronts: they offer a good source of income in the form of rents, with the potential for pockets of rental growth in locations and sectors that are exhibiting economic strength; they provide the potential for capital gain over the medium to long term should the properties rise in value; and they bring diversification to a portfolio with property historically performing differently to other asset classes. These dynamics combine to make an allocation to commercial property a worthwhile consideration for Isa investors in 2014.

Marcus Langlands Pearse is co-manager Henderson UK Property Unit Trust

Key Points

UK commercial property offers the potential for capital growth as well as income should the underlying properties rise in value

Liquidity is a consideration as assets can take some time to sell, particularly in difficult market conditions

Location is important but the quality of commercial buildings and the types of tenants they attract are also of paramount importance