Nick Kelsall, fund manager, Premier Miton Investors discusses the current potential of commercial property in multi-asset portfolios.
As multi-asset investors, we have long been advocates of holding UK commercial property in our funds as part of a diversified portfolio and continue to see the merits of the asset class despite the difficult environment the sector is having to endure in the current rate tightening cycle.
Whilst rates began to rise in late 2021 from their pandemic induced emergency lows, it wasn’t until the market shock caused by Prime Minister Truss and Chancellor Kwarteng’s ‘mini budget’ that capital values in commercial property really felt the pain.
Since then, although rates continue to rise, valuations appear to have stabilised and yield shift has all but ended, leaving many property funds (we prefer closed-end REITS) at hefty discounts to their net asset values.
The recent release of inflation data which came in better than expected, could potentially be a turning point for the sector. However, in any event, provided there is a strong balance sheet in place, high rent collection and occupancy with resilient tenants, the relative cheapness of these funds could be viewed as an opportunity. Furthermore, the yields on offer now are substantially higher than they were last year, which all adds in favour to the income account.
Meanwhile, although the current inflationary environment has led to higher rates, rental growth has broadly benefitted from this, since many of the leases involved have an element of inflationary protection built in which helps to provide support for capital depreciation and grow that all important income stream.
Elsewhere, certain funds in the space are continuing to benefit from various factors such as demographics (primary healthcare and care homes for an ageing population), e-commerce (logistics, omnichannel shopping), and a tight labour market (student accommodation), to name but a few.
As we know, the widespread introduction of working from home (WFH) has had a huge effect on the way business is conducted and where individuals spend their income, and obviously has major implications for the office sector for which more than ever the old adage: ‘location, location, location’, rings true. WFH has provided greater choice and time for reflection on working environments so when this is coupled with a looming regulatory deadline to ensure buildings meet the required energy requirements, the best-in-class space will almost certainly come out on top, with the potential for substandard assets to be left stranded if asset management or a change in use is not viable.
Sometimes, real estate managers need to be pragmatic in terms of rental levels, and it is important that a close relationship is maintained with their occupants to ensure that the best possible outcomes are achieved and not just push for the highest rents. The recent pandemic provided a stark reminder of this when rent collection dried up for swathes of the sector but management teams that worked with their tenants and implemented a sustainable level of rent, tended to fare better than others. Whilst this may not always be ideal, especially in the case of dividends being rebased, it is important that managers recognise when difficult decisions need to be made to ensure future longevity and growth.
For now, the supressed ratings of property funds have meant that issuance in the market has all but evaporated and the focus has been on improving current portfolios and ensuring dividends are paid and debt is hedged. However, as mentioned previously, given the current higher level of yields available, and notwithstanding the relevant risks, commercial property has the potential to offer an attractive return over cash and still offers a valuable source of income for portfolios.
