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Property sector update

UK Commercial Property has performed phenomenally well recently, with the IPD UK All Property Monthly Index returning 51% over the last three years. This equates to a 14.6% annualised return, well ahead of UK equities (FTSE All-Share TR returned 7.2% annualised) and bonds (Markit iBoxx Sterling Corporates TR returned 4.8% annualised). However, the outlook for the sector is now considerably more subdued, and momentum seems to have turned. After three years of net inflows, Investment Association data have shown the first outflow from open-ended property funds in February 2016. In this article we take a detailed look at what is currently happening in the sector and what the future might hold.


Where have the returns come from?

The strong returns from commercial property have largely been driven by significant capital appreciation of the underlying assets. Total returns for the IPD UK All Property Monthly index for 2015 were 13.8%, of which 7.8% came from capital and 5.6% from income. The split has been similar in preceding years. Yield compression remained the principal driver of total return in 2015, reflecting the significant weight of capital which has entered the market in the past 24 months. Strong capital growth was the key theme of 2015 in the industrial and offices sectors, particularly in the West End and the City.

However, for the retail sector, income growth was the key driver of returns in 2015. We have seen this increasing contribution from rental value growth driving total returns from UK real estate. This is important in the current real estate market, as we are seeing capital values peaking and income returns (which are driven by rental value growth) are now expected to be the driver of future returns for the sector. The general consensus is that income will become the principal driver of returns over the next five years.


UK Property performance against equities and bonds

graph property 180516

Source: Lipper

Open-ended property funds and swing pricing

Open-ended physical property funds are a popular investment route, generally having relatively low volatility and being priced fairly closely to the net asset value (NAV) of the underlying holdings. Property is an asset class with high transaction costs, such as Stamp Duty Land Tax, which together can add up to 4-7%. To accommodate this, open-ended property funds may ‘swing’ their prices when they experience changes to the net flow of assets into or out of the fund.

A price swing involves the fund manager adjusting the share price (in single priced funds) or switching between the ‘bid’ and ‘offer’ price (in dual-priced funds). The mechanism is designed to protect existing investors in a less liquid asset class by pushing additional trading costs on to the net buyers or sellers, with a side benefit of providing a disincentive to trend investors. Managers who have ‘swung’ the prices on their funds have stressed that the changes are a reflection of current net fund flows rather than liquidity concerns.

Another option – Real Estate Investment Trusts

Other routes into property investments are Real Estate Investment Trusts (REITs) and other listed property companies, which allow for liquidity at short notice. Listed vehicles have secondary liquidity in their shares so investors can buy and sell their holdings on an exchange with a degree of certainty over price and how long the transaction may take.

Using REITs, investors are able to diversify their holdings between various geographical areas and property specialisations. REITs are liquid assets that can be sold fairly quickly to raise cash or take advantage of other investment opportunities.

What will the rest of 2016 hold?

The latest IPF consensus forecast predicts a lower, but still healthy, total return of 7.9% for 2016. The UK Commercial Property market’s underlying fundamentals remain sound, although the market can be affected by short-term negative sentiment such as Brexit.

Due to Brexit uncertainty, we have already seen slowing tenant and investor demand, which we expect to continue until 23 June. In terms of transactions, comments from fund managers suggest that this uncertainty has caused the property market to come to a standstill – and where transactions are going through, there are Brexit clauses being put in (for example, buyers can pull out in the event of a ‘Leave’ vote).

Should investors wait before selling?

Due to the outflows already witnessed in the sector, we have now seen three of our preferred property funds swing their prices – thereby dropping client valuations. Investors are now increasingly asking if they should wait for the price to swing back before selling.

It is important to remember that investing in physical property funds requires a long-term buy-and-hold approach, and that they shouldn’t be used as frequent trading vehicles. Short-term swinging prices shouldn’t influence long-term investment views, and it is important to also consider the liquidity of such funds. Solid income returns from UK Commercial Property are expected to continue to attract investors. Fundamentals of the market remain firm, with widespread rental growth resulting from increasing occupier take-up.

The value of your investment can go down as well as up, and you can get back less than you originally invested.

The Bestinvest Online Investment Service, including any account analysis and investment reports provided by our guidance services, is an online execution-only dealing service for investors who want to make their own investment decisions. It does not provide advice on the suitability of products and investments; if you are unsure about the suitability of any investment you should seek professional advice. Clients of our Investment Advisory Service and Managed Portfolio Service can use the website to obtain current valuations of their investments but cannot trade on these accounts online and should call their adviser if they wish to discuss changes to their investments.

Past performance or any yields quoted should not be considered reliable indicators of future returns. Restricted advice can be provided as part of other services offered by Bestinvest, upon request and on a fee basis. Before investing in funds please check the specific risk factors on the key features document or refer to our risk warning notice as some funds can be high risk or complex; they may also have risks relating to the geographical area, industry sector and/or underlying assets in which they invest. Prevailing tax rates and relief are dependent on your individual circumstances and are subject to change.

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