Interactive Investor

Commercial property post-pandemic: what’s next for the sector?

13th July 2021 10:46

David Prosser from interactive investor

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Investment trusts and funds investing in bricks and mortar were hit hard by Covid-19, but the big picture now looks favourable.

For evidence of the resilience of bricks and mortar, look no further than UK commercial property. This is a sector that was hit hard by Covid-19: the pandemic forced retailers to close their doors, sent office workers home and disrupted industrial operations and logistics.

Yet investors who stayed patient survived relatively unscathed: FE Analytics data reveals that from 1 January 2020 to 1 July 2021, the average fund in the Investment Association’s UK Direct Property sector is down 1.6%, while the average trust in the Association of Investment Companies’ (AIC) UK Commercial Property sector is up 0.8% over that time frame.

Moreover, the big picture now looks favourable. Rising inflation is unnerving some policymakers, but commercial property often performs well during inflationary periods. As the economy expands and demand increases, rents tend to grow, which makes property a good hedge against inflation. Indeed, many commercial property leases include an inflation link, guaranteeing landlords additional income if the cost of living rises.

Still, while the rising tide that an end to the pandemic represents has the potential to float all boats, prospects vary across the sector, argues Andrew Burrell, chief property economist at Capital Economics.

“The easing of restrictions is good news for the economy, but some commercial property sectors will be slower to benefit than others,” says Burrell.

He adds: “With rental growth prospects still poor outside the industrial sector, we expect limited downward pressure on yields and modest growth in capital values in the near term. Further out, office and retail face structural headwinds, which leaves industrial as the stand-out performer over the forecast horizon.”

Clearly, investors in some areas of UK commercial property will currently be feeling more positive than others. In retail, the pandemic appears to have accelerated long-term trends in the sector that do not favour investors in bricks and mortar outlets, whether in large shopping centres or on the high street.

In particular, online retailing’s share of total retail sales in the UK rose from less than 20% before the pandemic to a peak of 36.3% in January 2021. And while that figure has now slipped below 30%, it remains well above pre-Covid-19 levels. The list of big-name retailers going into administration, closing stores or restructuring in some other way only underlines the problems facing traditional businesses. Landlords letting retail units to such tenants face tough headwinds.

That said, some investors still have faith in parts of the retail sector. At BMO Commercial Property Trust (LSE:BCPT), director of property funds Matthew Howard says footfall in some of its retail holdings is now higher than prior to the crisis. “We also have a strong conviction that the leisure and food and beverage sectors will bounce back quickly,” he says.

Similarly, Richard Shepherd-Cross, manager of Custodian REIT (LSE:CREI), points to the strength of pockets of the retail sector. “Many essential retailers in out-of-town retail parks prospered through lockdown; food, discounters and DIY all traded strongly,” he says.

“Much of what consumers enjoyed about out-of-town shopping - convenience, free parking, click and collect and easy returns - will be every bit as valid as the economy unlocks and can be complementary to online shopping,” adds Shepherd-Cross.

In the office sector, the backdrop is one of similar doubt amid a widely shared conviction that many people will continue working from home, even after Covid-19, at least for some of their time. “Increasing numbers of businesses are considering downsizing their real estate footprint in the face of uncertainty over how much space will be required going forward,” says Scott Harkins, head of the commercial division at real estate specialist Carter Jonas. “By the same token, fewer occupiers are proceeding with their office relocation plans.”

If the work-from-home phenomenon does prove enduring, demand for office space will naturally be diminished. But landlords able to adjust to the new environment will be in a strong position, argues BMO’s Matthew Howard. In any case, he suggests, predictions of the end of office life may prove to be overdone.

Trends such as hot-desking and flexible working are nothing new and offices have been adapting their spaces accordingly for a number of years,” Howard says. “Although there will be more flexible working arrangements moving forward, we still expect the majority of office space to return to near pre-pandemic levels of occupancy during the middle part of the week, plus a greater need from occupiers for more collaboration areas and meeting pods for video conferencing.”

Elsewhere in the commercial property sector, the impacts of Covid-19 are strong drivers of positive performance. The obvious example is logistics, where surging online sales have hugely increased demand for warehousing and broader fulfilment infrastructure.

Moreover, it is not only retailers and their distributors that need this additional capacity. They are competing with businesses ranging from food producers to medical suppliers. Strong demand for data centre space – crucial to support the move of the UK economy online – is another consideration. And in manufacturing, where the pre-pandemic trend towards just-in-time supply chains was reducing the amount of space required, many businesses are now rethinking this model.

Richard Moffitt, chief executive officer of Urban Logistics REIT (LSE:SHED), says this area of commercial property is buoyant. “We have seen unprecedented growth in the structural adaptation to e-commerce.

“It is inevitable that this structural shift will continue - all our warehouses, bar three which closed for a few days at the beginning of lockdown, remained operational during the pandemic,” he says.

Andrew Bird, managing director of Tilstone Partners, an adviser to Warehouse REIT (LSE:WHR), says landlords cannot open capacity quickly enough, pointing to Knight Frank research suggesting that e-commerce growth will generate demand for an additional 92 million square feet of warehouse space in the UK before the end of 2024.

“Supply remains very constrained with Knight Frank estimating there is currently only 10 months of available stock,” says Bird. “This acute shortage of supply will continue to drive rents from their historic low base; this will ensure the sector continues to outperform throughout the medium term.”

Some of this outperformance may already be in the price. Analysis from the AIC suggests that property funds focused on UK logistics delivered returns of 56% over the year to 30 April, against 22% from the broader sector.

Nevertheless, the data is a reminder of the diversity of the UK commercial property sector. As Britons return to workplaces and go back to the shops, there will no doubt be opportunities for property investors to benefit from the post-pandemic recovery.

But the broader story is the changing dynamics of sector: many commercial property specialists are focused on how to support the structural transformation of the broader economy. And that may be where the biggest winners are to be found.

Open-ended funds versus investment trusts

Regulatory reform of property funds will be one enduring impact of the Covid-19 pandemic, with regulators finally losing patience with the use of the open-ended fund structure in the sector.

The problem for open-ended funds is that property is an illiquid investment – it takes time to sell physical property, particularly if you want to secure a decent price. By contrast, funds promise daily liquidity to their investors – that they can take their money out at a time of their choosing.

In a crisis, this mismatch causes huge problems, with funds struggling to meet redemption requests from large numbers of investors heading for the exit. Last year, most open-ended commercial property funds were forced to close their doors for several months – locking investors out of their money.

Having seen this happen time and again – most recently in the wake of the Brexit referendum – the Financial Conduct Authority is proposing to reform the way in which open-ended property funds operate. Final regulation is expected later in the year.

However, while open-ended funds insist they have a future, investors need not wait for the regulator’s assistance. Unlike open-ended funds, investment trusts do not face a liquidity problem. The structure of an investment trust means investors can buy and sell its shares on the stock market irrespective of what is happening to the underlying portfolio.

“Retail investors have surely had their fingers burnt once too often from investing in open-ended property funds,” argues Shepherd-Cross.

“The liquidity promise cannot be met, income returns are not competitive and long-term returns have tended to fall short. Property investment companies should be the natural home for capital looking for real estate returns.”

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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