Some sectors of the property market could be ripe for a revival. Cherry Reynard asks experts for trust tips to profit.
In early December, the government extended its ban on evicting commercial tenants. While it gives UK companies some much needed breathing space, it extends the pain for property funds. They have faced 12 months where tenants haven’t been obliged to pay rent, but can’t be replaced. It has cut off their income stream and depressed the value of their buildings.
Property fund managers have complained that many businesses are exploiting the rules – refusing to pay even when they can. A measure that was designed to help struggling hospitality and retail businesses has, they suggest, been abused by other sectors, with landlords left powerless. However, the government has shown no sign of budging, recognising where public sympathies lie.
Trust discounts widened in 2020
Unsurprisingly, this has had a disastrous impact on returns for commercial property investors. The average property investment trust is down 15.6% year-to-date in mid-December. This weakness can partly be explained by a widening of the discounts, which in 2020 reached up to 50% in some cases.
The open-ended UK Property sector is down a more modest 3.5%. However, many funds in the open-ended sector have been closed to redemptions since March and valuations may not have caught up to reality yet. Gavin Haynes, investment consultant at Fairview Investing, says: “Investment trusts tend to be more volatile because they are daily traded and will fully reflect the future values of the underlying assets.” He believes there is likely to be another round of pent-up selling when all of the open-ended funds allow trading again. To date only a handful of open-ended funds have re-opened their doors.
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There is also the problem of dividends. Many commercial property funds have cut their dividends, by around 50%. Given that many investors use commercial property funds as a source of diversifying income, this has been a nasty shock.
Those funds with high retail holdings have been hardest hit. Investment bank Berenberg recently downgraded the Capital & Regional REIT (LSE:CAL), which has a portfolio of regional shopping centres, believing its problems to be “almost insurmountable”. Retail property giant Intu collapsed into administration in June 2020.
So far, so gloomy. However, it is important to point out that some parts of the commercial property market have been more resilient. Specialist property trusts focusing on growing segments have, in some cases, been beneficiaries of the pandemic.
Thomas McMahon, senior analyst at Kepler Partners, says: “Healthcare, residential and logistics have seen more resilient income. The first two have largely government-backed revenues, while the final has benefited from the shift to online retailing and the ability of much industrial activity to run through the pandemic. In the care home REITs, investors received a double whammy: wide discounts in March and April have closed, while income has been maintained, so those who bought into weakness have had a good year.”
Light at the end of the tunnel?
Are there brighter times ahead for the commercial property sector? After all, the 4% plus yields on offer for many funds and trusts, do look more appealing. The vaccine roll-out is under way, bringing a possible end to economically damaging lockdowns. Many property managers have negotiated rent deferrals rather than waving rent altogether, so there may be small windfalls for some funds as the economy reopens.
The government has said that the latest extension to the eviction ban will be the last, although it has extended it twice. It is due to stop in March and after that point, landlords will be able to replace non-paying tenants once again. This should be a boon for the beleaguered commercial property market and there may be some revival in valuations.
That said, it is clear that different parts of the property market have markedly different prospects. Richard Williams, property analyst at Quoted Data, says: “The retail sector has been in the press almost on a weekly basis with yet another retailer failing - but the writing has been on the wall for that sector for some time. As demand for shop space continues to recede, rental levels - and thus valuations - still have some way to fall before coming to an equilibrium.
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“However, there could be some value in the retail park sub-sector. These edge-of-town retail parks have been tarred with the same brush as shopping centres but have completely different characteristics. The units tend to be let to retailers on cheaper rents than high street stores and have become the go-to for some established high street names, such as Next (LSE:NXT) for click-and-collect purposes, and growing retailers, such as discounters Home Bargains, B&M Retail (LSE:BME), Aldi and Lidl. Due to their location, they also have alternative use value, such as residential or urban logistics.”
At the same time, logistics look set to go from strength to strength as e-commerce gathers steam. Recent data from IBM’s US Retail Index suggested the pandemic had accelerated the shift away from physical stores to digital shopping by approximately five years. Funds such as Aberdeen Standard European Logistics Income (LSE:ASLI), which invests in logistics assets across Europe, is up 27% over the past 12 months to mid-December and still has a yield of 4.5%. Tritax Big Box (LSE:BBOX), which does the same in the UK, is up 18.9%.
Williams adds: “The trend to online retailing has accelerated during the pandemic, which has resulted in a surge in demand for space. Demand for space has also come as occupiers look to shore up their supply chains having suffered a shock at the beginning of lockdown as the flow of goods from Asia all but stopped and panic buying ensued.”
Investors need to watch the valuations of these trusts because they can trade at chunky premiums to their net asset value. Equally, McMahon suggests that the sector may be exposed to any weakness in consumer spending. Williams points to Tritax EuroBox (LSE:BOXE), which is still trading at a discount and was recently given an endorsement by Aberdeen Standard Investments, which acquired a 60% stake as it looks to grow in the logistics sector.
Return to offices will boost property sector
The office market is a tougher one to call. The working from home revolution may ensure, or it may fade as people seek out the companionship of an office environment once the pandemic is over. Haynes says: “It is important to identify which areas of the property market are in cyclical decline and which are in structural decline. To our mind, retail appears to be in structural decline, while the office market could revive. In some cases, the office market is pricing in a very negative scenario and we believe people will go back to working in offices.”
James Calder, research director at City Asset Management, agrees: “My instinct is that people will go back, but not everyone all at once. Companies will probably space people out a little more rather than let leases lapse. It’s not dreadful news, but it has taken the edge off the market.”
That said, the sector is facing some non-pandemic related pressures. More people are self-employed. At the end of 2019, the Office for National Statistics reported more than five million self-employed people in the UK, up from just over three million in 2000. They now represent 15.3% of employment, up from 12% in 2000. The pandemic has prompted many people to re-evaluate their lives and self-employment may continue to increase from here, further reducing demand for office space.
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Niche property trusts tipped to bounce back in 2021
Other niche sectors may be due a revival. Haynes suggests medical facilities, such as GP practices and care homes, may be another area to look at. These can be accessed through investment trusts such as Target Healthcare REIT (LSE:THRL), Primary Health Properties (LSE:PHP) or MedicX.
Williams believes that student housing REITs may be an interesting recovery play: “These will have a poor 2020-21 academic year, but any return to normality in 2021 could see demand from overseas students returning. Prior to the crisis GCP Student Living (LSE:DIGS), for example, had a premium rating, whereas post-dividend cut it is on a double-digit discount.”
However, few see brighter prospects ahead for the traditional UK open-ended property funds, which are still struggling with the wrong structure. William Dinning, chief investment officer at Waverton Investment Management, says: “The issue of owning illiquid assets in liquid funds has been a problem for many years. Since 2008, many UK open-end commercial property funds have had to ‘gate’ on three occasions (2008 in the global financial crisis, 2016 post the Brexit vote, and then in 2020). Each gating was for different reasons, but the underlying problem is the same. We do not believe that owning open-end property funds makes sense.”
Haynes points out that many of these funds are stuck with assets that they can’t readily sell. “They can’t suddenly sell all their retail holdings and buy doctors’ surgeries. They are not in a position to move quickly.” Open-ended funds still need to hold high cash weightings to preserve liquidity, which acts as a drag on returns. They are likely to face selling pressure when they unlock. In addition, the results of an imminent review by the regulator into the sector is also creating uncertainty, with the introduction of notice periods being implemented on the cards.
There are parts of the property market that are under real stress. Some of that stress may be reflected in today’s prices, but until funds unlock, it is difficult to tell. Investors would do better to focus on those specialist trusts geared to market recovery.
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