Property as a regular source of yield

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With yields having fallen across most assets in recent years, there has been much debate as to whether we have entered a ‘new normal’ and if this is forcing income seekers to ‘move up the risk spectrum’. While this may present some challenges for income fund investors, there is no great cause for concern in the current economic environment.

There are still plenty of opportunities for investors to source attractive yields across a broadly diversified opportunity set, without having to increase their overall risk profiles. Currently, preferred sources of income include US credit, selected non-mainstream government bonds, and developed market – especially European – equity. However, an allocation to property can also be considered.

Property can be an appealing way to increase the level of diversification in a portfolio invested in equities and/or bonds. This is because it tends to perform differently in varying market conditions. Furthermore, the performance of commercial property is normally less volatile than that of stockmarkets.

Diversification across geography and sectors, such as offices, industrial and retail, aim to minimise risk.

Commercial property offers the prospect of a regular income with some capital growth. Over the long term, income is likely to make up most of the total return – typically this can be more than 70 per cent.

Appeal of commercial

Rental income from commercial property has a number of attractions. Rent is paid by tenants on a regular basis over the duration of the lease, which can last five or 10 years, sometimes longer. Rents are normally reviewed every five years and the rent is generally only revised upwards. Furthermore, there are some areas of the property market where investors can get increases linked to the retail prices index, such as with supermarket tenants.

Property yields have been declining since the first half of 2013 as investors have competed for limited stock. In the case of some prime central London property, yields have fallen to levels not seen since before the global financial crisis. Nevertheless, yields are still generally attractive and rental income from property should continue to grow.

Rental income is increasing in all the main commercial property segments, led by strong growth in the office sector. According to the IPD UK Monthly Property Digest, rental growth was 0.6 per cent in 2013, followed by 3.1 per cent in 2014. Annualising the growth rate for the first eight months of 2015 gives a figure of 4.1 per cent.

Preferred areas

Rental growth is expected to remain robust, with increased economic activity producing rising demand for property. Supply, meanwhile, remains tight; a lack of development means supply is still below the long-term average.

Sectors favoured include offices outside central London, retail parks and distribution warehouses. There are some attractive investment opportunities among good secondary buildings, where yields are higher and the gap between the yields on good secondary and prime properties has partly narrowed.

Steven Andrew is manager of the M&G Episode Income fund


Richard Levis, global real estate analyst at Aviva Investors, offers his thoughts on the outlook for UK real estate

“In the near term, we expect returns from UK real estate to be strong. This is largely because real estate is likely to remain attractively priced relative to other asset classes, especially government bonds. When the interest-rate environment begins to normalise, however, we believe the downward pressure on yields will abate.

We therefore think performance is likely to moderate over the long term, especially when yield compression gives way to modest rental growth as the main driver of returns. Our five-year all-property total return forecast for 2015 to 2019 remains relatively unchanged from the last quarter, averaging 8.8 per cent per year.”