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August/September 2013: Concrete investment

Written by Andrew Holt
August/September 2013

The projected returns on offer to charities through commercial property investment are highly attractive, says Andrew Holt

Sponsored by The Charities Property Fund

LIKE THE properties themselves, commercial property investment is built on solid foundations, as there are a number of reasons for charities to have commercial property as part of an investment portfolio or invest in a commercial property fund.

Fundamentally, the projected returns on offer are highly attractive. According to the IPD UK Annual Property Index average property returns were 3.4 per cent last year, although values did fall by 2.2 per cent. IPD’s quarterly index, which is based on a slightly smaller sample of properties, recorded a 2012 return of 2.7 per cent and a fall in values of 3.1 per cent, but all indications seem to suggest now is a good time to invest as return prospects are perking up for 2013.

For commercial property, investors should expect average annual returns of between 6 per cent and 8 per cent over the next few years, depending on the region, according to RREEF, an investment adviser. ‘Risk-on’ assets such as equities have already seen the benefits of loose monetary policy and commercial property could be next.

Between 2001 and 2012 for example, income return accounted for 6.2 per cent per annum of the 6.4 per cent per annum total return delivered by the asset class.

And this stable and predictability in terms of cash flow expectations is attractive to income focused charities. Though on average capital values are still 37 per cent below their 2007 peak and in real terms, an incredible 50 per cent below their previous high.

Capital values
Within this though opportunities exist. At a time of rising asset prices, commercial property represents a pocket of value charity investors should be investing in. Capital values outside London have hardly recovered from the lows of 2009. And some of the money going into London in the past few years will extend into the UK’s regions as confidence in the economic recovery increases.

Moreover, European commercial property has delivered a total return that has exceeded bonds and equities over 5 and 10 year periods. Capital growth is returning off the back of renewed sentiment for the sector and enhanced interest at occupier level.

In terms of current pricing, property not only offers the opportunity to capture capital value growth but can be viewed as quite defensive due to its high income yield of 6 per cent plus and also relative capital value position compared to other asset classes which are close to or above their peak.

“These are attractive returns,” says Richard Gwilliam, head of property research at M&G Real Estate. “With low bond yields, and we expect commercial property income yields of 8 per cent this year and 9 per cent for the next three years: this amounts to a very attractive option for charities.”

The news over the past few years about commercial property has often involved doom and gloom, with premises becoming vacant and some companies being tipped into insolvency by their property commitments. But a lot of problems were due to the fact property had been acquired years ago on inflexible terms, such as rents that were too high, or having to pay three months rent in advance.

Commercial property has matured as an asset class, with growing investor recognition of its attractive risk-return characteristics and the diversification benefits of holding it in a multi-asset portfolio. “The commercial property market has evolved considerably over recent years, particularly with the pressure resulting from the tough economic times.

“There are now deals on offer which could make it worthwhile fro investors to dip their toe into property before things change. I believe there is unlikely to be a better time to do deals and, in some cases, property can be just the launch pad needed to move to the next level,” says Angela Dennis, a commercial property specialist from solicitors Russell-Cooke.

There is real evidence of the money chasing central London Assets, which have largely recovered in capital value terms, heading into the regions together with Institutional money which has been unable to deploy cash in the central London market. Gwilliam notes that some South East Offices could even see double digit returns of 15 per cent next year, a major boost for any charity investment portfolio.

Current appeal
Indeed, the persistence of low income returns across investment markets creates significant challenges for long-term, income dependent investors such as charities. Andrew Allen director of global property research at Aberdeen Asset Management observes this, but with a qualification.

“Arguably, UK property has distinct current appeal given the high income return that the sector produces and there is a perception that capital values should be a beneficiary of this. Whilst we observe allocations to the sector remain high,
demand for high quality properties robust, we suggest it is incorrect to assume that all boats will rise on this tide.

“Charities must be mindful that property investment market strength is at odds with the underlying occupational markets in many instances. Whilst the UK economy appears to be stabilising, it remains too early to suggest that rental growth will reappear in many property markets, for example, many High Street locations are structurally in decline, provincial office markets challenged by oversupply.

“Conversely, the more robust occupier markets, particularly in London, are appealing to a very broad cohort of investors, both domestic and from overseas, a consequence of this is that the price of ‘prime’ assets is already high, the income return from such assets much lower than for the sector as a whole.”

This raises the question of what an appropriate property strategy might look
like for Charities, particularly if they are largely risk-averse and income dependent.

Allen says in terms of themes within the property market, Aberdeen continue to favour high quality and durable income streams, meaning dominant assets where tenants have little alternative, substitution, choice; illustrations might be a dominant supermarket, or an industrial estate in a densely populated urban area.

Allen adds: “Given the uncertainties of the economic fundamentals for much of the property market we remain largely risk averse, we are not generally seeking
to exploit secondary quality property strategies nor are we seeking to undertake
complicated asset improvement programmes, we believe it is incorrect to do so particularly on the simple relative basis that prime property is now seen to be expensive.”

Though of course, a key factor for charities is that property is a long-term investment. Sarasin Partners in its Compendium of Investment, notes that commercial property has something of the character of equity investment and something of the fixed interest investment. Its equity investment is in the sense that tenants are often commercial enterprises whose ability to pay their rent depends on their profitability. The fixed interest is that rents are static between reviews that may be years apart. Property also has some inflation hedging characteristics if, as seems likely, the printing presses continue to operate under the governorship of Mark Carney.

The advent of REITs, it has been argued, may well change the property landscape, from one that has historically been illiquid asset, into a liquid taxefficient asset. Currently investments in REITS offer income returns at the lower end of the 6 per cent plus range offered by commercial property common investment funds. Though the F&C REIT has recently issued its latest forecasts indicating above 8 per cent annual returns for each of the next 5 years.

Income return
Also important is that commercial property has a high proportion of total return from income return: as commercial property is fundamentally an incomedriven asset class with the majority of long-term performance generated by a high and stable income stream. F&C are still focused on the income side of commercial property which it feels will make up 90 per cent of returns over the period to end 2017. An increasing and steady improvement in returns is forecast over the medium-term – although F&C recognise that forecasts are never quite as smooth as actual returns.

Guy Glover, fund manager of the F&C UK Property Fund, believes that whilst capital values are recovering he sees 80 per cent of the future returns emanating from income: “It is clear from the long term that income provides the stable and reliable return. Portfolios should seek to deliver this in the first instance, whilst acquiring properties which have capital growth potential, by first and foremost having the ability to deliver capital growth from improving the income stream.”

As part of a charity portfolio commercial property could be 10-15 per cent as the norm within a multi–asset class portfolio says Gwilliam but in some cases more than 20 per cent. Another option is to invest in common funds specifically set-up for charities that invest in commercial property and yield good returns of around 8 per cent. Another alternative is to invest in real-estate investment trusts, which, as has been suggested, can offer income returns at the lower end of that range.

Potential upside
“Charities should also invest in property in line with their overall approach to running the charity and its investment methodology,” observes Glover. Glover
also notes that investors looking for potential upside are focusing upon the relatively low level of the capital values of commercial property compared with the market peak and the high income yield.

They are also considering the potential upside to capital values from a rerating of commercial property and are increasingly turning their attention to property now gilts, corporate bonds and equities have all seen significant repricing. “Whilst recognising the relative position of capital values we are aware of the headwinds coming from sluggish performance of the UK economy and from abroad but are cautiously optimistic about their future direction,” notes Glover.

James Thornton, fund director and chief investment officer at Mayfair Capital, adds: “Given the uncertainty created by Federal Reserve Chairman Ben Bernanke’s comments about the impending end of QE, investors are growing apprehensive about the pricing of bonds. With growing confidence in the UK economy, commercial property is seen to be an increasingly attractive asset class for charity investors.”

Commercial property therefore continues to justify its role in a diversified investment portfolio, and investment in a commercial property fund, given the highlighted yields is an area charity investors should be looking at, particularly given the current uncertainty and volatility across other asset classes.

Andrew Holt is editor of Charity Times



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