UK commercial real estate provides an ideal form of income for investors seeking income in a diversified portfolio. The return from real estate can be split into two parts; income and capital.
In times of positive GDP and a growing economy, there is a reasonable prospect for capital growth in the asset class. Last year’s capital growth of 12 per cent was the highest since 1993, and is unlikely to be repeated for some time; however the fundamentals look reasonable for the next couple of years at least.
The income component for real estate returns comes from tenants paying rent. The UK commercial real estate market is attractive to investors because the standard market leases are generally longer than most global markets and have what is known as an upward-only rent review. This type of review means that the income will not drop during the duration of the lease. The income is relatively secure as, unlike dividends, the tenant has a legal obligation to pay the rent under its lease contract. As a result, UK commercial real estate is able to provide a sustainable, attractive and growing income to investors.
The average income yield for UK commercial real estate is currently 5.5 per cent (according to IPD); however every property is different and so there is a very wide range of yields available to investors. The use of leverage can also enhance the income return where the cost of debt is less than the income yield; however this does lead to greater capital volatility.
If an investor is looking for a secure income stream then an annuity style investment such as a long let supermarket or logistics unit can be bought. This very secure income stream however, will have a much lower yield – probably in the low 4s (per cent). This suits some investors, but does not really provide a high income yield compared to other income products.
At the other end of the scale, investors can buy properties yielding over 9 per cent, and even well into the teens; however this income is normally at risk and secured against poor quality properties. It is rarely sustainable.
The middle ground is where most funds operate. The real estate income investment trust sector generally seeks to offer investors an attractive income return with the prospect of some income and capital growth. The funds in the sector are mainly listed vehicles, generally structured as REITs, and so pay investors a dividend. The current dividend yield in the sector compares favourably against lower yields on other assets such as government bonds.
Fund managers in the sector generally look to enhance and grow the dividend over time. So how is this achieved?
First, the fund manager will seek to invest in a diversified portfolio of offices, industrial / logistics units and some retail.
The individual investments are selected to provide a balanced portfolio of good quality properties let to good tenants and in good locations. Some are low-yielding and other assets are higher yielding providing stability and also opportunities to grow the income from the assets.
Income in the sector is maximised by actively managing the portfolio investments. Fund managers generally meet with their tenants to understand their real estate needs and seek to renew leases and remove break clauses in advance of the lease expiring which aids the fund’s overall security of income. Meeting tenants and providing good quality accommodation that works for them and enables their business to function is one of the key aims of the fund manager. In turn, meeting tenant needs is fundamental to generating acceptable returns.
With economic growth and very limited supply of good quality accommodation in most markets (there has been virtually no new speculative development in the last eight years, albeit it has picked up modestly lately), the market is now seeing rental growth again and this is likely to continue for the next few years.
Properties without tenants obviously do not provide an income, so fund managers in the sector look to minimise voids. The sector void rate compares favourably with the overall benchmark index void rate. The benefit of having good quality buildings in locations that tenants want to be, is that buildings can be purchased at an attractive yield and are let on shorter leases. Logistics units in particular are attractive currently as they have low levels of depreciation and the growth of online retail has led to increased demand from retailers to store and distribute goods.
Some of the funds in the sector utilise leverage, but broadly only at moderate levels. The use of leverage helps to enhance returns but caution is needed with debt though, as was brought home in the last downturn, and as we move further through this capital cycle, LTVs in the sector are likely to be reduced rather than increased.
Now is a great time to be investing in real estate. We are still relatively early in the rental growth cycle, with continued strong tenant demand expected and pricing currently looks attractive relative to other asset classes. We forecast an annual average total return of 7.1 per cent over the next three years with the majority of this coming from income.
Diversified portfolios focused on income with moderate debt should be able to provide an attractive sustainable income with prospects for growth to investors over the foreseeable future.
Jason Baggaley, Manager of the Standard Life Investments Property Income Trust
Key Points
Investors seeking income in a diversified portfolio should consider investing in UK commercial real estate
If an investor is looking for a secure income stream then a long let supermarket or logistics unit can be bought
Properties without tenants obviously do not provide an income, so fund managers in the sector look to minimise voids
