Property is the asset class that most of us know best; that’s because we’ve got ample experience of renting or buying our own homes, but despite this, it’s generally under-represented in most individual investors’ portfolios.
Why? Well, property can seem daunting. Yes, most people understand the principles of leasing, renovating and investing in a physical asset with intrinsic value, but the scale and time horizons involved in commercial property can be intimidating. So individual investors often stick with the stock and bond markets, even at a time when volatility and interest rates are rising, and when many valuations look stretched.
That’s where real estate investment trusts (REITs) come in. The investment-trust structure is especially well suited to property investments and offers an easy way to access the attractions of the asset class.
One of the most appealing aspects of property is the regular income it provides. Yields on UK commercial property are significantly higher than those available from bonds and equities.
Those attractions are considerable. One of the most appealing aspects of property is the regular income it provides. Yields on UK commercial property are significantly higher than those available from bonds and equities, and this income is remarkably steady – making it especially attractive at a time when stock-market volatility is rising. With bond yields still extremely low by historical standards, property presents a prime source of reliable income.
This steadiness is inherent to the asset class. While stocks and bonds can be sold in seconds, selling property can take months or years, but this lack of liquidity insulates investors from the panic selling that often causes slumps in security markets.
Market crashes can stem from sentiment as much as anything else, but because the sale of property assets can’t be achieved at the touch of a button, the prices of those assets are much steadier. That’s why the UK property market has been able to deliver incrementally positive growth with only a fraction of the volatility of the stock and bond markets.
Because of this stability, property offers significant diversification benefits. That’s why most professional investors include a property allocation in balanced portfolios. And there’s plenty of scope for diversification within the asset class too. Take the office sub-sector for example: although yields from London offices are not currently compelling, offices elsewhere in the UK offer much better prospects.
In the same way, retail warehouses allow investors to benefit from Britain’s changing shopping habits at a time when online competition is savaging the high street.
There’s also the question of what you’re actually buying. Property is a physical asset. That provides a level of resilience that you don’t get with financial securities. Yes, the property market can experience downturns. But those downturns are limited by the fact that land and buildings are finite. If a company goes bust, its shares are worthless. The same applies to bonds in case of defaults. But land will always have value. As the American humourist Will Rogers said, “they ain’t making any more of the stuff”. So property provides a degree of security that the security markets simply can’t match.
Because it’s a tangible asset, property also offers some built-in protection against inflation. Tenants naturally expect to pay higher rents at a time when wages and incomes are rising. Also, leases for commercial tenants often contain ‘step-ups’: provisions to ensure that the income from the property rises over time.
Today, of course, we’re in an environment of rising bond yields, as central banks normalise their monetary policy. If inflation continues to rise, the Bank of England will continue to raise interest rates to combat it. That’s a serious consideration for fixed-income securities; higher rates mean higher bond yields and lower bond prices, but it’s far less of a concern for the property sector, where borrowing is low and the relationship between interest rates and yields is much more complex.
In fact, it’s even possible that rising interest rates will restrict the supply of new property – making the existing stock more valuable. That’s because tighter monetary conditions will make it harder for developers to borrow, and with less cheap money in the system to fund the building of new property, demand will focus on what’s already there.
Then there’s the question of asset management. Unlike many other asset classes, property provides significant opportunities to improve the quality of the investments themselves. Again, this is something that most of us understand intuitively, as we know how renovation can transform domestic property, and the opportunities to improve commercial assets are considerable.
Take an out-of-town shopping centre, for example. It might be a good investment as it stands, but a skilled management team can make it a great investment through improving the facilities, attracting appropriate tenants and enhancing the experience for consumers. The prospect of adding significant value through the management of individual assets is something that sets property apart – making it an option that all forward-looking investors should consider.
So how can individual investors access the experienced managers that can add real value? There are plenty of funds that invest in commercial property. But the idiosyncrasies of the asset class make it ideally suited to investment trusts. The investment trust has been with us since 1868. It predates unit trusts and open-ended investment companies by decades, and there are good reasons why this tried and tested structure is still going strong.
One of the main advantages of investment trusts is that they promote a long-term approach.
One of the main advantages of investment trusts is that they promote a long-term approach. That’s because their closed-ended structure allows their shares to be traded on the stock exchange without requiring any action on the part of the trust itself. Accordingly, the manager can focus entirely on the portfolio’s holdings, instead of having to worry about redemptions, liquidity and lock-ups.
This is crucial, because it means that investment-trust managers can stick with their long-term strategy regardless of short-term market ‘noise’. And it’s especially beneficial in asset classes with long cycles, such as commercial property. The structure of investment trusts also means that their managers don’t have to contend with the costs of creating and redeeming new shares – and nor, therefore, do their investors.
In contrast, when an open-ended fund faces client redemptions, the manager will often have to sell assets to meet them. So, when investors withdraw large amounts of money from the fund, the manager can be forced into selling the most liquid assets to raise cash, regardless of their longer-term prospects.
Perversely, this forced selling puts the interests of redeeming investors ahead of those that keep faith with the fund. Even worse, the manager may have to impose lock-ups during volatile periods, to prevent investors from withdrawing their money en masse.
The advantages of the investment trust apply especially to commercial property. While shares and bonds can be sold at the touch of a button, buildings take time and patience to sell. So, by avoiding the need to raise capital when clients reduce or withdraw their holdings, the investment-trust structure is ideally suited to the asset class. That’s why REITs have become so well established in the UK since their introduction in 2007.
And because an investment trust doesn’t have to keep a high cash balance to cope with redemptions, it can stay fully invested in the manager’s chosen assets. That should entail higher overall returns than open-ended funds, as the higher cash holdings of the latter will tend to create a drag on performance when markets are rising. This is a particularly important point for the property sector. Because of the illiquid nature of property assets, open-ended property funds are usually compelled to hold between 10% and 20% of NAV in cash in anticipation of redemptions.
This should be a key consideration for investors. If you put money into a property fund, you want all it at work in the asset class. If you wanted a proportion of your money to be invested in cash, you could put it in a bank. Why pay a fund manager to do it for you?
The ability to use gearing is another important factor enabling investment trusts to achieve higher returns. According to research from Canaccord Genuity, the average property exposure of UK REITs is 131% of NAV, compared with just 78% for large open-ended funds. That gives investment trusts a considerable head start when it comes to NAV performance.
The benefits of that head start are well attested. Over the past decade, UK commercial-property REITs have delivered an average annualised NAV return of 7.0% and an average shareholder total return of 10.9%. This compares with just 4.3% for their open-ended peers.(1)
The stock market’s inherent volatility also creates opportunities for long-term investors to buy into REITs at attractive prices. Investment trusts often trade at a discount to their NAV, but this will tend to narrow over time, allowing investors to benefit from entering during periods when the discount has been exacerbated by irrational sentiment or panic selling.
Another attraction of REITs is their dividend policy. Unlike open-ended funds, investment trusts can keep back up to 10% of their income to smooth out their annual dividends. This helps them to deliver a steadier stream of payouts, and the fact that they can be fully invested means that that income will be higher, all else being equal, than the income from an open-ended fund with a higher cash balance.
All in all, then, REITs combine a robust and dependable asset class with a structure that offers considerable advantages in management focus, investor income and overall returns. And with other asset markets looking increasingly uncertain, it’s an opportunity that investors shouldn’t pass up.Over the past decade, UK REITs have averaged an annual yield of 5.3%, compared with just 3.0% for open-ended commercial property funds. So REITs are an obvious choice for income-focused investors.
(1)Canaccord Genuity, 10 years to 30 September 2018
Author - Calum Bruce of Ediston Property Investment Company.
Focus on Funds
This article was featured in the first edition of Focus on Funds magazine.
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