Commercial property: a new phase in the cycle

By Jason Baggaley, Fund Manager, Standard Life Investments Property Income Trust Limited

  • Commercial property is an asset class that has demonstrated strength and resilience in recent years.
  • The cycle is mature, presenting different challenges and necessitating an active approach.
  • Careful management of assets and meeting tenants’ needs will be vitally important.

Aside from some minor wobbles, commercial property has seen a lengthy period of capital growth in recent years. As with bond and equity markets, which have also seen a strong run, a more nuanced approach is needed as we move to a late cycle phase. Today, yields are low and price rises have slowed. Nevertheless, there is considerable disparity in underlying markets, and this is where active managers can take advantage.

Real estate is heavily impacted by the turmoil associated with Brexit as it has a strong correlation with the strength of the underlying economy. There has also been a lot of attention on the impact of changes in shopping habits recently, but in reality this is a far more complex and diverse asset class, which has become an integral part of many investors’ portfolios.

While the Brexit story is evolving and changing, the retail story is more structural, and is likely to have long-term implications. Retail has been the serial underperformer for the last few years. Shopping centres and retail warehouses have been worst-affected, along with secondary high streets. In contrast, industrial property has been the darling of the market, benefitting from the consumer shift towards internet shopping and home delivery. Prices have risen, demand has been high and it has shown real rental growth. Standard Life Investments Property Income Trust (SLIPIT) has over half of its assets in the industrial/logistics sector and this has been a strategic overweight position for some time.

Forecasters expect that industrial will continue to lead the performance tables, with retail at the bottom, over the next few years. Such a collective view impacts on market pricing. Although industrial is great to own, it is now expensive to buy, with prospective purchasers generally having to price in future growth.

Retail is harder to own, but it might provide the better buying opportunities. Investors will need to apply strict criteria to invest in retail assets to ensure they will continue to provide a reliable income stream and remain attractive for the tenant. Buying in the retail sector will have to be bottom up, asset by asset.  Having reduced retail exposure in SLIPIT to circa 9% over the last five years we now have an open mind to making selective purchases again.

So far we have concentrated on the best and worst performing sector, but there is a third area: offices. At a sector level, offices have held the middle ground in terms of market performance. Central London offices dominate the headlines and are considered most exposed to Brexit risks, but overseas buyers have so far helped hold up prices. SLIPIT has limited exposure to central London offices, having preferred to focus on the South East/Thames Valley area. Here, we have been realising some profits and reducing risk by selling assets where we see tenant demand weakening or significant capital investment requirements.

There are no immediate difficulties for the sector, but how offices are used is going through as much change as the retail sector. The way we live and work is changing – commuting is not popular with millennials and amenities are important if companies want to attract and retain talent. Work places need to have a ‘buzz’, but also practical elements such as good quality showers, a bike rack, a decent coffee machine in reception and good Wi-Fi.

Where does this leave us as fund managers? There are no easy solutions. Commercial property has been strong for 10 years and yields are low today by historic standards. With a slowing economy, expectations for rental growth are being reduced. Unusually for this stage in the cycle, there is however a limited supply of new space. Previously the property industry has over-developed at later points in the cycle, leading to a glut of accommodation, but that seems muted this time round. At the same time, we expect interest rates to remain low for a while, and the attractive yield from real estate is likely to continue to attract investors.

And there remain real opportunities for those with the resources to look asset by asset. To our mind, the most important aspect today is asset management – visiting tenants and ensuring that their needs are properly met. This cannot be outsourced. At Aberdeen Standard Investments we have a capable team of asset managers and like to take an active approach. This is reflected in renewals and longevity of tenant relationships. In a difficult environment, there is great value in retaining tenants.

It should be said that this market is easier for us to navigate due to the closed-end nature of Standard Life Investments Property Income Trust. As an investment trust, every decision we make is made on the basis of what we believe is in the best interests of shareholders and subject to scrutiny by the board of directors. Property doesn’t need to be sold to meet redemptions and we can buy at a time when there are outflows from the sector which can provide attractive opportunities. Our hand is not forced, so we are always in a position to shape the portfolio according to market conditions as we see them.

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