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Understanding the commercial property cycle

Understanding the commercial property cycle

Commercial real estate has always been a cyclical asset class. Understanding where we are in the cycle is as important as ever, especially given increased macroeconomic uncertainty following the UK’s decision to leave the European Union. A greater understanding of the property cycle may hold the key for investors seeking to overcome upcoming headwinds.

‘As well as the cyclical nature of real estate there is also a life cycle to the underlying assets. As investors, we have to understand both these cycles’ says Jason Baggaley, manager of the Standard Life Investments Property Income Trust (SLIPIT).

In the past, political influence has tended not to dictate the patterns of property investment.

However, 2016 was strewn with surprises and we saw a much greater influence from the political environment, with the UK property market suffering in the immediate aftermath of the EU referendum. Commercial property values fell by 1.3% in 2016, according to the MSCI/IPD quarterly index, although the total return over 2016 remained positive at 3.5% given property’s reliable income return.

Although political and economic uncertainties remain, the fundamental characteristics of commercial property, and particularly its potential to provide a reliable and predictable income stream, make it a suitable asset class in which to invest in the current environment.

‘Commercial real estate can give a diversified, sustainable and predictable source of income,’ notes Baggaley. ‘One of the main things we focus on,’ he added, ‘is providing an attractive level of income.

SLIPIT currently provides a dividend yield of around 5.5%, which is fully covered.’

Rental income is likely to shine through in the coming year and remain high enough to keep total returns on the positive side. Standard Life Investments forecasts an average annual total return of

3.8% per year for UK commercial real estate over the next three years, giving Baggaley added confidence. ‘The lease structure in the UK is very supportive of a healthy and predictable yield.’

For the veteran fund manager, simplicity remains the key to approaching real estate investments.

‘I’ve got a relatively simple investment approach. I like to invest in good quality assets, in good locations let to good tenants.’

Once the fundamentals are in place, focus then turns to generating sustainable yield. ‘Yield is important obviously. We firmly believe in having a covered dividend,’ says Baggaley, with SLIPIT aiming to deliver an attractive dividend with prospects for future growth.

Finding a pricing entry point is crucial to generating yield, however. Here Baggaley opts for a riskier approach. ‘I buy slightly shorter leases than the market average. A lot of people think that increases risk. [But] I’ve found that it gives you the opportunity to re-gear leases, particularly in times like this.’

‘Clients respond especially well to discussing lease renewals in a challenging economic environment, as it gives them the chance to focus on running their businesses rather than having to find, fit out and move to a new property. Tenants would really like to get on with running their own affairs rather than moving, which is hugely expensive, time consuming and disruptive. We can maintain a high level of income, through shorter leases,’ claims Baggaley.

Harnessing debt provides another avenue to generate income. ‘We do have debt in SLIPIT, which is very attractively priced and has a huge benefit on the revenue account. Our all-in cost of debt is about 2.7% with an income yield from the portfolio of over 6%.’

Understanding the nuances of each asset also provides a valuable perspective on how to obtain growth. ‘We need to use the differences of each asset as a guide. We strive to use this bottom-up approach to ascertain how the investment is likely to perform. It is extremely important to understand what occupiers want, and to ensure we have assets that meet their needs. This is especially the case during periods of change, such as in the retail and home-delivery sectors, and in offices where the work environment is an important factor for companies wanting to recruit and retain talent.’

Despite the political risks ahead, Baggaley remains optimistic about the future. ‘There has been very little development of new buildings in most markets, and supply of good quality accommodation remains constrained. This supports continued prospects of rental growth, especially in the industrial sector, in which SLIPIT is overweight. Our view is that capital values are likely to be supported as well over the next couple of years by the healthy margin in real estate yields over bonds, and the likely ‘lower for longer’ interest rate environment in UK. The weaker pound has also maintained overseas interest in UK commercial real estate and it feels as though the immediate doomsday predictions in the summer of 2016 after the Brexit vote have been proved wrong. SLIPIT has performed very well up to this point and we believe it is well positioned for the future.’

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The opinions expressed are those of © Standard Life Aberdeen as of July 2017 and are subject to change at any time due to changes in market or economic conditions.

This material is for informational purposes only. This should not be relied upon as a forecast, research or investment advice.

The value of an investment and any income from it can fall as well as rise and is not guaranteed. An investor may get back less than they put in. Past performance is not a guide to future performance.

Issued and approved by © Standard Life Aberdeen.© Standard Life Aberdeen is registered in Scotland (SC123321) at 1 George Street, Edinburgh EH2 2LL. © Standard Life Aberdeen is authorised and regulated by the Financial Conduct Authority.

© Standard Life Aberdeen, images reproduced under licence.

This article was provided by Standard Life Investments and does not necessarily reflect the views of Citywire

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