FTAdviser.com

Advertising

One of the chief strengths of open-ended UK property funds has turned into a weakness over the past 12 months. During the property boom, their flexible inflow/outflow structure enabled them to gather huge assets and fees. But as the market tide receded, so did investors, and UK property funds were forced to sell their assets too quickly. High redemptions famously forced some managers to suspend withdrawals altogether.

For investors still keen on UK property but find the events of the past year disturbing, closed-end funds may gain in appeal. Short of bankruptcy, UK Reits guarantee their own liquidity, as investors cannot alter the number of shares on a whim. Shareholders also avoid the initial management charge of an open-ended structure.

Some types of UK Reit provide features that are harder to come by in an open-ended UK property trust. The ING UK Real Estate Income trust, which is listed on the London and Channel Islands Stock Exchanges, offers a very high yield, currently running at 9 per cent. One unfortunate reason this figure is so large at present is because the value of the portfolio declined 36.1 per cent over the last year, in line with many other funds in the UK property sector.

Michael Morris, manager of the trust, says this type of yield is not unusual for Guernsey-listed Reits, which he estimates now average 9.5 per cent. But whatever your aims in property, he observes, closed-end structures are a simpler means of achieving them.

“I have been saying for some time closed-end structures are better suited for real estate. Your investment strategy can be totally driven by what you want to achieve,” he says. “If you are an open-ended manager, at any time you might have money coming in when you don’t want to buy real estate. Equally, now might be a dreadful time to sell real estate, but if people are heading for the door, then you have to sell to meet redemptions.”

For investors, considerations other than liquidity might deter them from putting their money in Reits. The most obvious of these are discounts and leverage. In a sense, these simply make the value of a Reit share more volatile – better for the seller if a fund trades at a premium in an upturn, or worse for the seller if it trades at a discount in a downturn.

The reverse, however, is true for the buyer. At the time of writing, the discount on the ING fund was 33 per cent, which Mr Morris says is approximately the UK peer group average, so in terms of discounts, UK Reits may be a buyers’ market at present – unless you believe these discounts will widen further.

Leverage is a different matter. “Over a full cycle gearing is accretive to returns in property,” Mr Morris points out. “There are times when it works against returns and there are times when it significantly enhances them. Those assets with gearing will see more bounce on the rebound.”

Debt currently backs 31 per cent of the ING fund’s gross assets less current liabilities. In other words, the portfolio is geared up 45.4 per cent over and above its NAV. Mr Morris says this is comparatively low compared with the 55 per cent average gearing on a European property fund. At 40 per cent, the discount on a European property fund is also comparatively high. But, at what is proving a difficult stage in the credit cycle, retail clients may think twice before investing in any leveraged vehicles.

Mr Morris recognises debt is a difficult issue at present. “We’ve been reducing our net cost and net levels of debt because we recognise the waters have got choppier,” he says.

One important consideration as far as Reits are concerned is the extent to which a fund’s income can cover its interest payments. Mr Morris says the ING fund’s cost of debt, including interest, is just over 5 per cent of the total amount of debt in the portfolio. Rental income on the portfolio is currently 6 per cent.

Mr Morris can therefore use the rental income on the debt-backed portion of the portfolio to pay for its own costs. He distributes the rental income on the equity-backed portion of the portfolio to investors as a dividend. Gearing up to buy assets not only pays for itself, but enables Mr Morris to construct a larger, more diversified portfolio for investors.

Problems arise if rental income on the debt-backed portion of a portfolio fails to cover the cost of the debt. Mr Morris said such concerns recently prompted him to sell a Tesco’s supermarket in Chester, whose yield fell to below 5 per cent, although he managed to sell it for £2m more than the upper limit of its valuation.

Mr Morris classifies retail space as the least attractive type of commercial property from an income perspective. Retail, retail warehousing and leisure were his bottom three sectors as of the end of last year, at 18, 7 and 4 per cent of the portfolio. He says industrial property offers the best opportunities for income, but fewer hopes for capital appreciation. It constituted just 27 per cent of the fund at the end of 2007 compared with 45 per cent for office space.

Mr Morris is also keen on property yields outside of London. His portfolio is geographically diverse, with a 24 per cent weighting in the south east excluding the capital, 18 per cent in northern England and 10 per cent in the Midlands.

Despite his big weighting in higher-income sectors, investors will be relieved to hear Mr Morris is trying to handle his debts prudently. He explains he has a big commitment to the fund, although he only started managing it in March last year. In 2005, he helped ING buy a substantial property portfolio from Abbey. Forty-five assets from this portfolio seeded the Reit when it was launched in October of that year, and 40 of them remain in the trust today.

The challenge for Mr Morris is to convince investors UK Reits are still a profitable proposition in the short term. In the medium and long term, demand for UK property and the sheer shortage of space in the country make for a more attractive case. But as the closed-end structure still has its detractors, it is up to Reit managers to seize the opportunities their unfortunate open-ended peers have created.