For an asset class that forms the basis of a cliché about safety, property’s decline amid the credit crunch has soured many investors on the sector.
A 45% peak to trough drop from 2007 to 2009 will do that, but with the sector long known for its income profile, many yield-hungry investors are taking another look.
Advocates are now highlighting property’s return to its long-term role as a source of income, particularly with Western government bonds at 300-year lows.
Ignis UK Property manager George Shaw, for example, says income has been the key driver of the sector’s returns over the last 12 months and will remain so in the future, in stark contrast to the massive capital gains available during the early Noughties boom.
With income integral to performance, Shaw says property is a unique asset class because it is possible for investors to influence and enhance this key return stream.
‘Our strategy involves managing income through measures including rent reviews, lease restructuring and physical improvement to our holdings such as refurbishment,’ he says.
‘We continue to see income as the core driver of property returns, and asset management initiatives such as handling lease expiries and maintaining lower vacancy levels are therefore at the heart of our approach.’
As an example of how Ignis has managed its assets, Shaw highlights steps the group took to improve yields on its Ellenborough House property in Cheltenham. ‘Following a refurbishment programme throughout 2011, we were able to restructure our lease with long-term tenant Rickerbys Solicitors for 60% of the accommodation with a 15-year deal,’ he adds.
‘We have also found new tenants for the residue of the property, which is now 85% let. This refurbing, re-gearing and attracting new tenants is the kind of proactive management that can enhance our income stream.’
Since the downturn in the property sector began in 2006, Shaw says the asset class has returned to its long-term return profile, swapping massive fluctuations in capital value and
tracking equities for solid yield and steady growth.
‘When talking to clients, our line is that commercial property will produce steady positive total returns, made up primarily of around 6% annual income with some capital growth,’ he adds.
‘This year is providing difficult for all asset classes but we are confident in our focus on proactive income management income in a portfolio with stock over sector calls and a London bias.
‘Sentiment remains negative as the economy struggles and the impact of the eurozone crisis on asset prices including commercial property plays out. But the stability of prime rental income streams, the yields available compared with cash and safe haven government debt and the huge volatility in equity markets represents a strong case for prime/investment grade property in these turbulent times.’
Meanwhile, Don Jordison, managing director of Threadneedle Property Investments, says for an asset-backed, relatively low-volatility investment, property offers a very attractive level of income.
For Jordison, the bounceback from the worst depths of the 2007/08 crisis has run its course and the sector has returned to a more typical pattern.
‘Over the long term, income is by far the most important component of performance and is particularly appealing against a background of extremely low interest rates that look likely to remain that way for some time to come,’ he says.
‘While the investment case for commercial property may not hold the same excitement it commanded in the heady days of the rebound, observers anticipate reasonably good income returns for this year, making the asset class an attractive option in the current environment.’
Like Shaw, Threadneedle says active management initiatives to generate capital and rental value gains will be key for property managers.
‘Rental agreements are signed on a long-term basis and this, together with the highly diversified rental stream in a well-managed fund, affords excellent income visibility,’ Jordison adds.
‘In a property market where total returns are likely to be dominated by rental income, a sustainable high income yield will make a big contribution to future property returns.’
Apart from income, Jordison also highlights another long-touted advantage of property, namely as a valuable portfolio diversification tool.
‘Historically, commercial property returns have tended to have a low correlation with returns from equities and bonds, because the asset class does not necessarily react to market or economic conditions in the same way,’ he adds.
‘Within the property asset class itself too, there is significant scope for diversification because each sector has its own drivers and opportunities, while different locations, property types and tenants provide further opportunity to spread risk.’
Elsewhere, Aberdeen analysis highlights UK property as marginally overpriced at present but the group points to assets let on long leases to secure covenants as a particularly attractive income alternative to governments bonds, index-linked paper and cash.
John Danes, director, property research, at the group, says the differential between long-let property and government bond yields is at close to 20-year highs.
‘Bond-like property with rental growth tied to inflation is also attractive in that our inflation forecasts are significantly higher than our forecasts for open market rental growth for commercial property as a whole over the next five years, so income growth should also be stronger,’ he adds.
‘The most attractive long income property types are supermarkets in particular, but also infrastructure and social housing,’ Danes says. ‘There are a variety of attractive alternative forms of long income, but it is imperative to ensure we are adequately compensated for the key risks of covenant strength and potential over renting.’
Lower returns from secure income
A risk of investing in long, secure income is that such properties are typically low yielding versus higher risk, shorter income assets with weaker tenants. As a consequence, Danes says capital values could be seen as vulnerable to a rise in yields from the current relatively low base.
’The key facts are long income property underperforms where rising gilt yields reflect expectations for a stronger economy and where the economy is operating at near full capacity,’ he says.
‘Conversely, it outperforms or matches All Property returns where higher gilt yields reflect a rise in investor inflation expectations, though not when inflation exceeds caps on indexation of leases.
‘In addition, given the depth of the economic crisis, interest rates and UK government bond yields look set to remain low for a long period, making any sharp upward pressure on property yields unlikely in the short to medium term. We expect the current flight to quality to be maintained during this period of economic uncertainty.’
Among advisers and wealth managers, appetite for property is yet to return in any great capacity. Mark Dampier, head of research at Hargreaves Lansdown, has been a long-term cynic on property and sees little reason to rush into the sector at present.
‘Although funds are still yielding in excess of 4% in many cases, no one is quite sure whether banks have started offloading excess property from their balance sheets,’ he says.
‘If not, that could be a large anchor weighing on the sector for many years to come. Banks still have more than £210 billion exposure to UK commercial property, with nearly a quarter of loans in breach of terms or default. More than half this debt has to be repaid by 2016, with around £50 billion due to mature this year.’
On the wealth side, Tom Becket, chief investment officer at PSigma Investment Management, currently has no exposure to UK or global commercial property, seeing little value within a wider portfolio.
‘The only justification we can find for property funds is diversification but we are against diversifying for its own sake,’ he says.
‘There are also better yield opportunities in high-yield credit and global equities, particularly after you take into account the charges and taxes applicable to property funds.’
Broadly, Becket is avoiding property globally as he believes yields do not compensate for the liquidity of the underlying investments within the Reits or the Reits themselves.
‘It was proved in 2008 that a combination of liquidity and leverage can be toxic,’ he says. ‘Unless we become genuinely convinced of a reacceleration of global economic activity, we are unlikely to soften that stance, particularly as in the UK and Europe, many of the financial situations are yet to address the property issues they collected in the boom years.’
Given PSigma’s longer-term expectations for serious inflation issues, Becket says it is worth exploring property markets that could provide some protection against this, and notes possible opportunities in Germany and Japan.
James Calder, head of research at City Asset Management, also holds no property at present, citing further potential for capital falls.
‘Yields are fairly attractive and the asset class has its diversification benefits but we can get better income from equities or high-yield debt and simply do not feel we are being paid to take property risk at present,’ says Calder.
‘Property is also not a homogenous asset class, ranging from retail, to office, to commercial, and the majority of managers we speak to predict another six to 12 months of capital falls across many areas.
‘We feel there may be better value available by next summer but then the access questions come in, as open and closed-end products both have issues for investors.’