August/September 2013: The right time.

Harry de Ferry Foster analyses the approaches to investment in commercial property

Sponsored by The Charities Property Fund

AS A CHARITY you have decided that negative real interest rates aren’t making best use of your cash; bonds are looking relatively expensive and the FTSE 100 is already up by over 12 per cent this year.

So, what are the alternatives? Commercial property (retail, office, industrial and alternative uses such as leisure, hotels etc) is an attractive option considering the high level of total return delivered through income (70-80 per cent), the improving economic picture and the benefit of having a real asset should inflation pay an unexpected visit.

But if you take the plunge, are there problem areas? Don’t you keep reading about high street retailers failing every week?

What you need to be able to do is choose the right parts of the market to invest in or find someone who can find them for you. You will also want to understand how you go about accessing and investing in commercial property.

Where should one invest?
1. Bond Style Investments

Many pension funds are switching out of corporate and Government bonds which are very low yielding and now perceived to be expensive. The 10 year Gilt yield at 2.3 per cent is currently below inflation with RPI running at 3.2 per cent. In effect you are losing money in real terms. Index-linked Gilts are yielding 0 per cent, so not much better.

It is possible however to access indexlinked property investments at yields of 4
per cent plus (for example: a Sainsbury’s supermarket with an unexpired lease term of 28 years with annual RPI increases, recently traded at a yield of 4.1 per cent — a 400 bps premium). Alternatively you can go slightly higher up the risk curve and acquire alternative assets such as a Premier Inn hotel. These can be acquired (with a guarantee from Whitbread) for yields of circa 6 per cent on the basis of a 20 year lease with rental increases based on the Consumer Price Index, compounded annually but payable every five years.

2. Industrial (manufacturing & distribution)
This sector remains high yielding (circa 7-10 per cent income yields depending on the length of lease and quality of asset) and investments can often be acquired at build cost, that is, 100 per cent of the value is tied up in the real estate rather than the lease.

The manufacturing sector has benefitted from the resurgence in the UK car industry over the last five years and the logistics sector has experienced strong occupier demand for space through the increased need for ‘just in time’ deliveries mand the rise of internet retailing.

There has also been a lack of new construction since 2007 as developers and banks have drawn in their horns; this, combined with low obsolescence and good occupier demand means limited empty space. Therefore this sector can provide a very high relative yield but with strong defensive qualities.

3. London
London continues to outperform the rest of the UK in economic terms and this is reflected in rising prices for real estate. Population growth is projected to continue to increase and the economic improvement is also being driven by regeneration (think Stratford, Kings Cross and Nine Elms) and infrastructure and spending (Crossrail).

Whilst UK investors have generally been priced out of the core area of Mayfair, there is still value to be had further afield in up and coming areas, such as Old Street/Shoreditch, Clerkenwell, Southbank and Vauxhall, to name a few.

However, stock selection and pricing remain key to making an astute investment. An example of this would be a building acquired on Albemarle Street, Mayfair in 2006 for £1,000 per sq ft, which sold in 2011 for £2,000 per sq ft (100 per cent increase). Conversely another institution over the same time horizon acquired an office building in Milton Keynes for £12million and sold five years later for £2million – an 84 per cent fall in value.

Hence the market as a whole can mask some huge discrepancies and is certainly not a “blanket buy”. You need to be discerning.

How does an investor go about investing in real estate and accessing these specific sectors?

1. Invest Directly
Just like buying your own house, this has the benefit of owning the property outright and being in complete control.

However, remember that direct property can be illiquid due to the long sales and marketing process compared with shares and bonds, plus you will also need to manage the building yourself and decide when is the best time to sell.

You would also need to decide whether you will be able to maximise performance by exploiting all the potential angles: refurbishment, redevelopment or change of use, and would you be prepared to suffer the fall in income whilst you do this or if a tenant went bust?

This may depend on your charity’s constitution – if you are a total return fund this may not matter, but if you are permanently endowed it may be more problematic. Generally owning directly tends to appeal to larger charities because they have the scale to be able to afford a large diversified portfolio of multiple buildings let to multiple occupiers. This means they are insulated in the event of, say a tenant default on an individual property.

2. Separate Account

Again, very similar to owning property directly – the main difference being that an existing portfolio or sum of money is placed with a trusted professional advisor who builds up, or manages, an existing portfolio on your behalf. This has the benefit of delegating decisions to the advisor who can then be judged on the strength of their performance.

This should provide you with a better service than merely using different advisors on an ad hoc basis as they will dedicate a team to your portfolio.

Should you be unhappy with the service provided, you will have the ability to put the mandate out to tender after a pre-agreed period.

3. Property Shares
An obvious way of accessing the commercial property market is to invest in the shares of FTSE listed property companies or REIT’s — such as British Land, Land Securities and Hammerson.

However these shares generally function in line with the stock market and tend to be low yielding. REIT’s also pay stamp duty so this is not a tax efficient way for a charity to access the commercial market.

Their major benefit however, is that they are liquid which overcomes one of the main issues of direct ownership.

4. Pooled Funds
These are funds that are set up with the aim of “pooling” together multiple investors to gain economies of scale and increased purchasing power. They allow access to a much larger and diversified pool of assets than you would be able to afford individually and to professional management. The best known example in the charity sector is the Charities Property Fund (CPF).

CPF was the first fund set up specifically for charities and is a Common Investment Fund. The Fund itself is a registered charity and is tax exempt, the main benefit being exemption from paying stamp duty (which is normally levied at 4 per cent on most commercial transactions), but there is no withholding tax payable either. The Fund is the largest charity specific fund owning almost £550million of commercial real estate, and is focused on the sectors which we believe have the best chance of outperforming the market. These include: London, industrial/distribution, supermarkets, index-linked assets.

In addition, CPF benefits from having an excellent regional diversification with 76 individual assets located across the UK and over 200 tenants (meaning no individual tenant failure would adversely affect the dividend). The Fund also benefits from having 21 per cent of its income secured on leases with fixed rental increases, meaning you are guaranteed some growth in income in the future.

The average unexpired lease term remaining is 9.6 years and the quality of tenants is very good. Over 80 per cent of occupiers are considered to have a negligible risk of failure (compared to the average portfolio of about 70 per cent).

The Fund is currently yielding 6 per cent per annum (net of all fees). Performance is also excellent having achieved 2.3 per cent for the second quarter of 2013 and is also good over the longer term — it is the second highest performing balanced fund in the IPD Pooled Property Funds Index over three years and is the best performing balanced fund over 5 years.

This is a considerable achievement bearing in mind it has grown from £190million to almost £550million (over 150 per cent) since 2009.

Liquidity has always been a criticism of pooled funds and certainly many pooled funds were shut for a period at the end of 2007 when the credit crunch hit. CPF was not immune to this and put a delay on redemptions in December 2007 in order to sell property and return equity to unit holders.

However, this was executed swiftly and all redemptions were cleared within the 12 month delay period allowed for under the scheme with half of the redemptions returned within 6 months — ahead of schedule.

Therefore, in its 12 year history CPF has only delayed redemptions on one single quarter, exhibiting a high degree of liquidity. Ironically CPF has actually had to turn new money away on three separate occasions due to investor demand – meaning it is probably harder to get into CPF than out, which is often the case with a strong performing fund.

Harry de Ferry Foster is director of investment at Cordea Savills

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