July’s fall in UK inflation, to 6.8%, will bring some comfort to those investors concerned about the impact of borrowing costs on real estate assets. The slowdown in the pace of price rises makes it more likely that we are close to or perhaps even at the point of, peak interest rates. There is no doubt that for those exposed to high levels of leverage, the possibility of rates pausing reduces some of the pressure on balance sheets.
However, we have always felt that for a diversified portfolio with exposure to UK and European real estate-focused equities and real estate investment trusts (REITS), as well as some select direct property investments, returns are not all about capital values which tend to have an inverse relationship with interest rates. For an investment trust such as ours, fundamentally, property is about income and having the ability to grow that income stream.
People often get caught up in the cyclicality of capital returns from property and forget about the core element of property’s total return – income. This is about businesses paying rent to occupy space. If you don’t pay rent, then you can’t occupy that space and for most organisations this is not a discretionary spend as without space to operate from they have no operations. Hence the reason why income from property is resilient even in mild recessions. At the close of the week which saw the release of the July inflation numbers, the dividend yield on the Trust was 5.75%*.
Growth is the second component of property’s potential return. It can come from supply demand imbalances (market effect) or from contractual obligations (indexation). On the Continent, index linked leases are the norm and they are increasingly being used in the UK. All this helps provide a degree of inflation protection over the medium term. However, for as long as the 5-year rent review cycle dominates in the UK that correlation will be weaker.
Sensitivity in the discretionary space
Back to supply and demand, in a slow economy such as that prevailing, a greater impact can be expected to be felt in discretionary property space such as retail, in comparison to sectors such as office and industrial. However, even in retail habits take time to change and leases time to expire. Therefore, we would not expect short/medium term demand to pare down excessively.
The equity portfolio is positioned in those markets where we see strong supply and demand dynamics and in companies with strong balance sheets. As well as the traditional sectors we have also acquired exposure to student accommodation, self-storage, retirement living, primary healthcare, hotels and supermarkets to name but a few alternative segments. We believe selectively investing across this host of sub-sectors can really enhance diversification within a portfolio.
Physical property is relatively illiquid so by complementing real assets with readily traded real estate securities we can secure better access to liquidity. At the same time, high costs and the practical realities of transacting in physical property can lead to higher cash balances in physical funds. By investing in real estate securities, a portfolio can remain more fully invested, countering cash drag. The hybrid structure also brings more active tools into play. For physical assets that means purchases/sales, redevelopment, and lease management. Within the equity component, stock selection and both sub-sector and geographic allocations are actively managed. And finally, adding real estate securities dramatically increases the fund’s reach and diversification via quality businesses across many subsectors and geographies.
Evolution in lifestyle steers changing demands
Looking ahead, sectors we like include industrials. Demand for industrial space has been steadily increasing (the result of growth in internet shopping, onshoring etc.) while supply has not kept up and even fallen in some urban areas. However, it is not just industrial that has benefited from rental growth – the medical, student and private rented residential sectors have all seen growth as well as specific retail assets, mainly retail warehouse and outlet villages. The ease of access and availability of parking is a spur to out of town retail parks where the growing popularity of click and collect supports ready footfall and offers tenants the advantage of communal facilities and shared costs.
Markets we want to avoid include shopping centres and offices (excluding super prime). Effectively the type of property that has a discretionary element to it. Offices have major and multiple headwinds at the moment – from sustainability upgrades to construction cost inflation to the challenges of working from home. These are just two good examples of markets we believe it is wise to avoid.
*Source: Bloomberg as at 18 August 2023
