Interactive Investor

This fund sector is bouncing back: how best to take advantage

26th April 2022 09:00

Faith Glasgow from interactive investor

This sector was hit hard by lockdowns, but is now in recovery mode. Faith Glasgow explains why the outlook has brightened and offers some fund and trust ideas.

When the Covid pandemic hit in early 2020 and economies worldwide were paralysed by lockdowns, the UK property market took painful body blows on many fronts as office developments, high street shops, leisure facilities and many factories fell silent overnight.

Investors had little option but to suck it up. According to Association of Investment Companies (AIC) data, investment trusts in the UK Commercial Property sector lost more than 10% over the second quarter of 2020 – which didn’t take into account the initial sell-off after the first lockdown was imposed; in the open-ended property sectors, numerous funds were suspended and several subsequently wound up.

But late 2020 and 2021 saw a gradual return to some kind of normality, and a recovery for commercial property overall. AIC figures show the UK Commercial Property sector returned 32% over the year to 1 April 2022, and 101% over the past 10 years despite the seismic impacts of both Brexit and Covid.

However, those headline figures mask marked polarisation within the UK market. Offices and some retail property have continued to struggle in the face of continuing uncertainty about life in post-Covid times. Meanwhile, industrials and warehousing have boomed on the back of consumers having more disposal income and moving online to shop, coupled with moves to outsource to more local suppliers to minimise supply chain disruption (known as nearshoring).

​​​​​Returning to form   

The AIC logistics property sector was up 39% over the year to 1 April; over three years it gained a massive 90%, in stark contrast to the commercial property sector, which was up just 17% over the period.

The outlook remains positive, according to Andrew Rees, associate director at broker Numis. Commenting on MSCI’s monthly property performance data to end February, he says: “Average capital values for All Propertywere up 1.9% in the first two months of the year (2.7% total return). This was once again driven by the industrials sector which was up 3.4%.”

Capital values for retail assets are up 1.5%, but this is mainly due to the retail warehouse segment which is up 2.5%, with other retail subsectors broadly flat. That said, Rees observes: “This is an improvement on 12 months ago, when standard retail assets were down around 1.8% in the first quarter.

He adds: “Offices have been broadly flat in the first two months of 2022, with ongoing uncertainty over the shape of occupier demand in the new normalpost-pandemic.

Is property investing an inflation hedge?

That pattern of outperformance by the industrial sector in terms of capital value growth, followed by retail warehousing and offices and with retail and shopping centres lagging, is expected to continue in the coming five years, according to the MSCI report. However, the current disparity between sectors is forecast to reduce over this period.

“From a total returns perspective, retail warehouses are now expected to deliver a similar return (7.0% pa) to industrial assets on a five-year horizon,” comments Rees.

Recovery in the property sector is good news for long-term private investors. As the AIC’s communications director Annabel Brodie-Smith points out: “In an environment where prices are rising, property can provide diversification and also help protect income and capital from inflation.”

However, Oli Creasey, property research analyst at Quilter Cheviot, warns of the need for “a degree of caution” when looking at property as an inflation hedge. He explains: “It is true that there is a correlation between property returns and inflation, but it is not as strong as some might think. Research has shown that property returns are inflation-linked, but even more influenced by GDP and the property cyclein general.

As a consequence, over the coming few years property investment may disappoint in this regard. “The inflation link is more likely to be observed over longer periods of time – were talking decades as opposed to years – which will smooth out property and economic cycles,” Creasey adds.

Rees makes an additional distinction between “demand-pullinflation driven by economic growth, and cost-push inflationdue to supply side pressures, such as the UK is experiencing at the moment.  

The former results in tenants “generally increasing their space requirements and also their willingness and ability to pay higher rents”, whereas the latter involves rising costs of production without an associated increase in demand. “In this environment landlords will struggle to effectively push through rental increases at open market rent reviews, and so real estate returns will be more challenged,” Rees warns.

There’s a further dimension to the inflation issue. Recent years have seen a greater focus on property with inflation-linked increases built into long-term (20-year) rental agreements, primarily in sectors such as healthcare, care homes and supermarkets. However, these rises are often capped.

“Many of these leases use collared inflation figures, which track CPI but only within the bounds of 2% to 4% a year,” Creasey says. “The high inflation being experienced today in the UK is often outside these bounds, and the landlord doesnt receive the full benefit as a result.”

Why investment trusts are a better fit for property

Nonetheless, there is good reason to seek exposure to UK property. In recent years the arguments for doing so via a closed-ended property fund have strengthened, as first Brexit and then the pandemic forced numerous open-ended funds to suspend trading and the Financial Conduct Authority (FCA) to consider more rigorous regulations for the sector. The most recent fund to close its doors is Janus Henderson’s £1 billion UK property, which announced in March that it is seeking a buyer for its physical property portfolio and feeder fund.

As Emma Bird, property analyst at Winterflood Securities, comments: “Open-ended funds have been suspended on multiple occasions because of volatile conditions. In contrast, while investment trust discounts may widen during periods of stress, shares can always be traded, albeit at a price that may differ significantly from the trust’s net asset value.

Bird makes the additional point that the closed-ended structure protects invested capital, so managers can minimise ‘cash drag’ – the need to keep emergency cash available against a run on the fund – and should be able to avoid being forced sellers in difficult markets.

She adds: “This is in contrast to open-ended property funds, which often hold notable cash balances in order to meet redemptions and may be forced to sell assets at inopportune times if they have insufficient cash.”

However, Creasey argues that there is “no perfect way” to make this fundamentally illiquid asset easily tradeable. Thus, although there will almost always be a buyer for investment trust shares, investors who need to sell may have to take quite a hit in volatile periods. “Even for those not looking to trade, their investment portfolio value can vary quite dramatically by the day or week due to this volatility, which is much less of a feature in the open-ended space,” he adds.

A further question for investors considering property is whether to opt for a generalist or a specialist.

Fund and trust ideas

If you plan to stick with an open-ended fund and risk suspension in preference to excessive share price volatility, there is little choice on the specialist front, so it’s a matter of selecting a generalist. Creasey picks out L&G UK Property fund as “one of the best in this class the fund is well-managed and has a large overweight to industrial & logistics property about as close as you can get to specialisation in this environment”.

He also mentions BMO Property Growth & Income (soon to be rebadged as Columbia Threadneedle) as a strong contender. “The fund is an open-ended hybrid, investing in both UK and EU REIT stocks as well as in direct UK property. The hybrid approach may not be perfect, but seeks to offer the best of both worlds - liquidity is offered by the REITs, but with returns from the direct assets dampening the share price volatility.

Among general property investment trusts, Bird highlights a couple of front-runners on attractive discounts, in the shape of BMO Commercial Property Trust (LSE:BCPT) and Standard Life Investments Property Income (LSE:SLI).

“In our opinion, the former offers core exposure to UK property and is a large, liquid fund that we believe benefits from an experienced management team. We consider the latter to be an attractive proposition due to its actively managed portfolio and strong ESG credentials,” she explains.

BMO Commercial Property is also the choice of Kepler’s analysts. “The lingering discount could make it, along with other generalist commercial property trusts, one of the last chances to get in on a Covid-19 recovery play,” they comment.  

“A huge amount of capital is being invested in real assets across infrastructure, renewables and similar sectors, with the shares of these trusts trading on significant premiums. However, commercial property offers many of the same attractive characteristics, and yet the trusts are largely on discounts.” 

BMO Commercial Property is also a member of interactive investor’s Super 60.

Rees picks out Custodian REIT (LSE:CREI), another member of the generalist sector but with a focus on small lot sizes. It has a yield of 5.5%. “Given the greater management intensity required to aggregate and manage a portfolio with more properties/tenants, the majority of larger funds will focus on buying larger buildings. This creates a pricing arbitrage, which Custodian REIT is able to take advantage of by fishing in a pool that is both under the radar of managers looking to deploy capital into larger assets, and above the threshold of private individual buyers,” he observes.

Specialist choices are more elusive, reflecting the high premiums prevalent across these sectors; but Winterflood recommends Impact Healthcare REIT (LSE:IHR), yielding 5.2% “supported by a portfolio of long-term, inflation-linked leases”. However, it may pay to wait, given the trust is currently on a 12% premium.

How the tipped property funds and trusts have fared 

Fund or trust  Six-month performance  One year  Three years  Five years 
L&G UK Property  4.2 19.1 24 40.9
BMO Property Growth & Income  1.8 14 19.1 34.6
BMO Commercial Property Trust  0.7 50.3 7.8 -5.1
Standard Life Investments Property Income 2.9 35.5 8.8 17.3
Custodian REIT  -5 7.6 0.1 14.6
Impact Healthcare REIT 7.6 15.1 35.3 52.7

Source: FE fundinfo. Data to 25 April 2022.  Past performance is not a guide to future performance.

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