Despite the popularity of commercial property sector pushing prices further upwards, property still remains an attractive prospect and can act as an effective diversifier in a balanced portfolio
The popularity of the commercial property sector grows unabated, with demand from both institutional and retail investors driving prices higher and pushing yields lower. However, despite valuations being on the full side we believe property is still an attractive proposition.
One of its key features is that there is little correlation between commercial property returns and those of equities or gilts, making it a great diversifier in a balanced portfolio. In addition, there is also little correlation between commercial property and residential property so any slowdown in the latter won't necessarily affect the former.
Performance
Market performance for 2004 saw total returns of 18%, and given the current levels, we are likely to see total returns for 2005 at around 15%. The main driver remains strong capital growth due to yield compression.
At sector level, contributions have come from all three main sectors. As expected, we have seen a lot of sector convergence in terms of performance in 2005 with industrials only slightly outperforming offices and retail. However, as we move towards 2006 and beyond we would expect the office sector to take some form of leadership.
Britannic UK property fund
The Britannic UK Property fund is one of the very few unit trust funds in the marketplace that can invest 100% in bricks and mortar. By doing so it offers investors full exposure to the commercial property asset class and all the diversification that it brings with it. This fund was launched at the end of 2004 with a mature portfolio of around £290m of commercial property: 120 tenants spread over 38 properties. The overall covenant strength across the properties within the fund is strong, with a large proportion of the income being derived from high quality tenants such as the government and major companies - many of them household names.
The fund is well spread both at a sector level and geographically, with an overweight position in industrials, neutral in offices and an underweight position in retail in comparison to its benchmark. This positioning has benefited the fund as industrials have been the best performer this year.
The diversification within the fund has served it well with performance coming from across the portfolio and not a just a few key properties. In fact, in its first nine months the Britannic UK Property fund has outperformed its main competitors producing an excellent 14.4% total return to end September according to IPD figures.* Commercial property is also a good income generator and the fund, which uniquely pays its income monthly, has a current yield of a healthy 4% which compares favourably with its peer group.**
As the fund has bedded in we have seen inflows of cash increase steadily and our cash holdings are now around 6%. This is a level where we can start to invest in further properties.
Our property team was recently boosted with the additions of investment manager, Sandy Thomson and asset manager Spencer Howard. Both come with a wealth of experience and will have a large contribution to make to the UK Property fund.
In addition to looking for new investment opportunities we are always looking at ways to add value through various asset management initiatives such as rent reviews, property refurbishments or extensions.
Acquisition strategy
We expect sector performance differentials in future to be significantly narrower than in the recent past. As such, our acquisition strategy will largely be stock specific. That said, we have a preference to increase our exposure to retail warehouse parks and offices over the coming months, which we believe will be positive for the fund as we expect these sectors to outperform over the next year or two. Much in 2006 depends on the level of take-up within the office sector: that in part will be influenced by the rate of GDP growth that we actually see next year.
Void rates, particularly in the key central London markets, are continuing to fall, albeit take-up rates have declined somewhat from the levels we saw for much of the last 18 months. Specific areas of opportunities are Central London, the better M25 and Thames Valley markets plus some regional cities where supply shortages are in prospect.
Market outlook
The outlook is still very positive, and in line with current thinking we anticipate returns in 2006 being at a more sustainable medium to long-term level of around 8%. This will allow commercial property to remain attractive without it suffering a slump. We believe liquidity will remain strong, but this can create its own problems. Because of the large increase in demand for property, competition has become intense and this reduces fund managers' ability to spend money as quickly as before. However, there is still substantial market turnover and we expect this to continue, creating many investment opportunities. We are firmly of the view that the fundamentals are in place to allow commercial property to deliver sustainable results over the next three to five years.
As with any investment there are risks and we would see the economic background as a potential issue, particularly given what we have seen recently in terms of oil price hikes and energy prices in general. Interest rates are also an issue but one has to give credit to the MPC which seems to have been effective in managing interest rate policy. Evidence suggests there are very few, if any, commentators who are anticipating significant interest rate rises in the short term. Indeed, our house view is that the next move is likely to be down which could give a further boost to investor demand for property.
Purely bricks and mortar
Changes in regulation allowing property funds to hold up to 100% in real commercial property have sparked debate over whether it is better to have a pure property fund or one with a mixture of property, equities and cash.
Investors who want commercial property exposure can get that directly through investing in a fund that holds the asset class. You can't get away from the fact that property share funds are investing in equities rather than property and, as such, performance will be more volatile than direct commercial property investment.
For investors who want the true benefits of diversification that commercial property brings, they need to choose a pure fund like the Britannic UK Property fund.
Past performance is not a guide to the future
The value of investments and any income from them can fall as well as rise and is not guaranteed. Exchange rate movements may cause the value of overseas investments to fluctuate.
Property investments are relatively illiquid compared to bonds and equities and can take a significant length of time to trade. This is reflected in the redemption terms. The value of property is determined by independent experts and is based on opinion rather than fact. Its value and any income from it can fall as well as rise and is not guaranteed.
*Source: IPD Balanced Monthly Index at 30/09/05.
**Yields as at 30 September 2005. Yields may vary and are not guaranteed.
