How to research commercial property funds

The FTSE 100 is off to a decent start, showing a capital gain of 3% to date, but the FTSE 250 is up by nearly 7%. This suggests that the dominant post-referendum theme of ‘pound down, stocks up’ is proving less powerful in 2017 than it did in 2016, as the more domestically-focused mid-cap benchmark is doing better than its better-known mega-cap counterpart.

There may be two reasons for this:

  • First, the pound has stopped going down. It held its ground as it neared multi-year lows of around $1.20 and has since traded between that mark and around $1.25.
  • Second, it just may be that last year’s underperformance by domestic names relative to exporters, overseas asset plays and dollar-earners created some value in sectors and stocks that were more dependent on the UK economy.

One asset class which truly found itself in the eye of the Brexit storm last year was commercial property.

The referendum vote to leave the European Union sparked concerns of an economic downturn and rush for the exit by financial services firms unable to ‘passport’ their products in the EU under the bloc’s rules, to the potential detriment of commercial property valuations and rents.

Yet such fears have yet to be realised and four factors may have started to stir fresh interest in UK commercial property:

  • UK Government bond yields have plunged from their February peak above 1.40% to barely 1.10%, again leaving investors looking for reliable sources of income, with property firms and their rental income streams one option to consider, especially as those rents are then often turned into juicy dividend payments to shareholders.
  • Several high-profile property deals in London have confounded the sceptics, as the buildings were sold at or even above their historic book value. The ‘Cheesegrater’, or the City of London’s Leadenhall Building to use its proper name, Vauxhall Square and Olympia are all examples of deals which suggest valuations are holding up well and not falling in the manner expected when property shares collapsed and property funds shut up shop last summer.
  • The buyers in the deals above were Chinese and German, while the Sunday Times newspaper has reported that a Hong Kong billionaire has built a big stake in FTSE 250 property company Shaftesbury, with a view to making a bid. The weak pound may be again tempting overseas buyers.
  • Finally, many stock-market quoted property developers and managers still trade at big discounts to net asset, or book, value, to suggest they may still be too cheap, in light of the deals outlined above and the possible bid for Shaftesbury.

Yet few if any advisers and clients will wish to take on the risk of buying specific property company shares.

A fund may therefore be a more suitable way to get exposure to commercial property while managing risk, providing advisers and clients feel that the overall asset class is suitable for their overall investment strategy, target returns, time horizon and appetite for risk.

Property investment trusts

The first table shows how the managed investment trusts which invest directly in UK property generally trade at a premium to net asset value (NAV).

This is a marked contrast to the REITs who form part of the FTSE 100 and FTSE 250 stock market indices, where discounts to net asset value (NAV) are the norm, at least for those property stocks with exposure to the development of new sites and buildings, the City and financial services, London more generally or (in some cases) all three.

The higher ratings enjoyed by the investment trusts may reflect their lack of development exposure and also the geographic and industry mix of their tenants (between finance, retail and industrial).

The one exception is the investment trust which invests not in buildings but the shares of the REITs:

Property investment trusts are generally trading at a premium to NAV

Source: Morningstar, The Association of Investment Companies, for the Property Direct – UK and Property Direct – Other categories

The investment trusts will offer a similar diversity of portfolio, to help advisers and clients mitigate risk and careful research will reveal which trust is more exposed to financial, retail or industrial sites.

However, the valuations on offer are high relative to the averages seen since 2005 (a period that encompasses the deep and frightening downturn seen during the Great Financial Crisis of 2007-09).

This suggests advisers and clients are still willing to pay up for the income on offer in the form of the dividend yield, which they clearly see as sufficiently dependable (or attractive relative to cash or Government bonds) to merit paying a premium to NAV.

Property investment trusts are generally trading valuations that are high relative to post-2005

Source: Company accounts, Thomson Reuters Datastream, Morningstar, The Association of Investment Companies, for the Property Direct – UK and Property Direct – Other categories

Note that the investment trusts do use gearing – or borrowing – to help to enhance portfolio returns (although this can also accentuate any losses during downturns), although the average figure of 24% across the sector is on balance lower than the average loan-to-value ratio seen across the quoted Real Estate Investment Trusts, as the subsequent table shows:

Property investment trusts’ gearing levels are lower than those on offer at the major quoted property development companies

Source: Company accounts, Thomson Reuters Datastream

By way of information, the next tables list the best performing property (closed-ended) investment trusts and (open-ended) funds.

In the latter case, all of the funds which closed and suspended trading or downwardly-adjusted their net asset values have recommenced dealings. These included Aberdeen UK Property, Aviva UK Property Trust, Henderson UK Property, Kames UK Property, M&G Property Portfolio, Standard Life UK Real Estate and Threadneedle UK Property.

Best performing UK property investment companies over the last five years

* Share price. ** Includes performance fee
Source: Morningstar, The Association of Investment Companies, for the Property Direct – UK category

Best performing UK property funds over the past five years

(Where more than one class of fund features only the best performer is listed.)
Source: Morningstar, for the Property – UK Direct category

That flap, however, is a reminder that property is only suited to those advisers and clients with a genuinely long-term perspective and property funds particularly so, as the underlying asset (buildings) is not liquid (it cannot be bought or sold quickly).

Advisers and clients using funds must therefore be aware that when the next commercial property downturn comes – and it is a matter of ‘when’ rather than ‘if’ – they may not be able to exit gracefully or quickly at the price they desire.

Tracking the trackers

For those advisers and clients who feel that commercial property fits with their investment strategy, target returns, time horizon and appetite for risk, one further option to research is using a tracker (or exchange-traded) fund.

There are two options here: the iShares UK Property Exchange-Traded Fund (ETF), which comes with the EPIC code of IUKP, and the iShares MSCI Target UK Real Estate ETF, whose ticker is UKRE.

It tracks the performance of an index of UK quoted REITs and at the time of writing its five biggest holdings are Land Securities, British Land, SEGRO, Hammerson and Derwent London, all members of the FTSE 100 or FTSE 250 indices.

The younger, and much smaller, iShares MSCI Target UK Real Estate is designed to track and deliver the performance of a different underlying benchmark index and the portfolio is quite different. While the other product is 83% equity exposed with nothing in fixed income, this tracker’s assets are 59% in stocks and 34% in bonds, with the balance in cash and other options.

This final table compares and contrasts their performance of the past five years, as well as their fee structures and current dividend yields. It may be that the fixed-income element of the iShares MSCI Target UK Real Estate tracker appeals to more risk-averse portfolio builders and the iShares UK Property tracker to more aggressive advisers and clients.

Trackers offer another way to seek exposure to property, albeit via listed stocks or bonds rather than actual buildings

(Where more than one class of fund features only the best performer is listed.)
Source: Morningstar, for Property Indirect - Other and Property Indirect - Europe categories

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.