CTI Chapter 3

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Introducing property to clients

By Holly Black

Look beyond London

By Cherry Reynard

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“Varying geographic exposure can shift the risk/return profile for investors”

Advice strategies

Commercial property has many of the assets investors claim to want in the current environment, and it has a role to play in improving diversification across portfolios. Some clients may be deterred by its complex history but both fund groups and the regulator have shown themselves to be increasingly wise to the problems. It may be time to look again at the sector.

Assets with assets

If a client wants diversification there are niche property vehicles, such as student accommodation, which are less economically sensitive. Or they might consider investing in an overseas property market. For income, regional UK property may hold more attractions. For a growing income, certain investors may seek out areas such as retail warehousing. However, when looking for a strong fund, Wellian Investment Solutions chief investment officer Richard Philbin tends to focus on a number of key areas: “Initially, I’d look at the diversification of the underlying assets and the holdings in each. If they have a £100m spread across 100 assets they may be diversified, but if they have £15m in one asset they may be less so. Large holdings always bring greater risks.” He also looks at geographic spread. “I don’t want to be fully exposed to the London market, for example,” he says, adding that yields differ considerably across asset classes and this will also inform his judgement on a fund. Tenant mix is also important. A fund might have 100 properties, but if they are all let to the same tenant or type of tenant the risks are higher. Philbin wants to see quality tenants and a good balance. Void rates are another consideration. “It’s important how much of the property is rented vs how much is vacant. The quality of the tenants and the length of the lease can add considerably to the value of the property,” he says. Costs tend to be higher for commercial property funds. This is because transaction costs are higher but also because managing a commercial property portfolio is labour-intensive. It requires surveyors, managers and lawyers. Whereas a £3bn to £4bn equity fund might have three to four team members, a commercial property fund could have an extended team of 15 to 20 people. Because this adds cost, it is vital those people really know their market and can add value. “The assets need to be worked hard and it takes an experienced team to do this,” says Philbin. In terms of allocation to different property types, Lowcock leaves this to the experts. “Conducting research on property is quite specialist so I’d delegate to a fund manager who specialises in the area,” he says. Haynes too tends to invest in plain funds that hold a blend of assets and where the manager decides on the asset allocation. For both Haynes and Lowcock, more difficult times in commercial property have alerted them to how a manager constructs their portfolio, particularly for open-ended funds. This will include how they manage the cash balance and create liquidity, how they have performed in previous market slowdowns and whether they are open and transparent with investors. Philbin believes that taking a look at who the co-investors in the fund are is also important. In an illiquid asset it is important to know that other large investors are not about to pull the plug.

So, if advisers decide commercial property merits a greater allocation in client portfolios, how can they decide on the appropriate strategy? Again, this will depend on individual clients.

It is clear weightings have been influenced by the liquidity problems of commercial property funds in the wake of the credit crisis. Yet the sector faced a similar test more recently in 2016 when money exited funds over Brexit fears and the outcome for investors has improved. Whitechurch Securities investment director Gavin Haynes says the wobble gave an insight into the better funds in the sector. “Valuations were relatively high and there was lots of money coming out of open-ended funds,” he says. “It was a stress test. We noted who handled it well, who kept us informed and which funds were shrewd, selling trophy assets in London and moving into other regions.” Any weighting in commercial property will need to be set against client need. It tends to be a slower growth asset but this is balanced by its income yield and stability. Architas investment director Adrian Lowcock says: “The income stream is significantly different from bonds or equities as it is harder for a company to pull out of its rental agreements than it is for it to cut a dividend. Therefore, in a slowdown, the property income is more stable than equity income and this is a consideration when building a portfolio. Property income can also have inflation-proofing built in, which again is important for income seekers.” Association of Real Estate Investment Funds chief executive John Fitzpatrick says: “There is no ‘typical’ consumer of commercial property, and how to hold it depends on what the client is holding it for. If it’s held in an Isa it may just be for a few years. If it’s held in a pension it might be far longer. That said, many major pension funds have weightings of 5 to 10 per cent towards commercial property. If you’re going to hold it in a portfolio, you need to hold enough to make it meaningful.” The commercial property weighting may also be dictated by the market. It is possible to argue that now is a good time to reconsider the diversification properties of portfolios. As interest rates rise and liquidity is withdrawn from the system it will have an impact on risk assets, and may create greater volatility. Perhaps more importantly, there is a danger that equity and bond markets sell off in unison. Multi-asset managers have long drawn attention to the limitations of a diversification policy based exclusively on bonds and equities. It has worked well while there has been abundant liquidity created by quantitative easing but investors may need to be more nuanced in their diversification strategy from here, and commercial property has a role to play in that. With commercial property, investors hold a ‘real’ asset. If a company goes bust, equity investors are left with nothing. If a commercial tenant goes bust, investors can re-let or sell. This should provide stability in a declining environment even if the pricing of commercial property weakens.

At a time when investors are starved of income choices and options for diversification, the average allocation to commercial property funds remains low. Are they missing a trick? The sector has left many of its problems behind and now looks a more stable proposition. How can advisers decide whether they should have a higher weighting in commercial property and, if so, where it should go? As it stands, only around 2 per cent of the overall UK funds market is in property funds. To put this figure into context, that is one-tenth of the amount held in UK equity funds and around the same as is held in money market funds. Even unloved absolute return funds are around three times the size. Far from homogenous, the asset class increasingly offers the potential to build different risk and return outcomes for clients. From retail warehouses to office space to industrial buildings, commercial property can be influenced by micro-economies within the broader economic picture and allows for a more nuanced strategy overall. Much of the flows into commercial property still go into a few large funds but there are high and low risk options. It is possible to take development risk, for example, where groups seek to improve deteriorating assets using strategies such as changing the tenant mix in a shopping centre or adding in new facilities. They may renovate dilapidated office buildings or, for warehouses, the focus could be on installing robotics to help with stock management. While all this can give higher returns, it does bring new risks. Varying geographic exposure can also shift the risk/return profile for investors. Large, mature economies will tend to have slower growth rates, while emerging economies may have faster growth in their property markets, albeit with commensurate risk attached. It is also worth remembering property markets operate in cycles: Germany may be in an upswing while the UK is stalling. All of that said, the FTSE Apcims benchmark suggests a commercial property weighting of just 2.5 per cent for ‘income’ or ‘balanced’ investors. This is around half the level it recommended prior to the global financial crisis and somewhat less that the traditional ‘with-profits’ model, where allocations of 5 to 10 per cent were not uncommon.

The role of property in asset allocation

By Cherry Reynard

Commercial property is increasingly offering the potential to build different risk and return outcomes for clients

June 2018

FTSE Apcims benchmarks suggest a commercial property weighting of just 2.5 per cent for ‘income’ or ‘balanced’ investors

2.5%

2.8%

The 10-year Treasury yield

Veteran investor Byron Wien suggested that the 10-year Treasury yield could rise. That would imply significant losses for those already invested in the Treasury market.

20 Fenchurch Street (the ‘Walkie Talkie’) was sold to a Hong Kong investor for £1.3bn.

In March 2017 a Chinese property developer paid £1.15bn for 122 Leadenhall Street (nicknamed the ‘Cheesegrater’)