Is commercial property back on the UP?

No asset class has endured more in recent years than commercial real estate, undermining its traditional role as a portfolio diversifier and important source of regular income.

Negatively impacted by the 2016 Brexit vote, the 2020 and 2021 lockdowns and financial market turmoil, commercial real estate has proven to be a disappointing investment.

For example, the average fund that invests directly in UK commercial property has generated a return of just under 2% over the past five years. Over the same period, the UK stock market – as measured by the FTSE All-Share Index – is up 16 percent.

However, this only tells half the story. In some cases, major real estate funds have had to suspend transactions due to a deluge of investors looking to leave – and the funds have not had enough liquidity (cash) to meet these withdrawals. This has led many investors to vow never to touch a real estate fund again.

While last year was also painful – the average UK direct property fund posted a 9% loss – some financial experts think the proverbial worm has turned. They argue that the doom and gloom has been exaggerated and that the sell-off has created buying opportunities for brave investors.

Commercial real estate includes everything from office buildings to shopping malls (in and out of town), industrial units and distribution centers run by the likes of Amazon. It can be in the UK or based abroad.

The financial mechanisms of commercial real estate are relatively easy for investors to understand. Investing in a fund managed by a professional manager gives investors exposure to a diversified portfolio of bricks and mortar. These properties generate a rental stream, most (not all) of which end up in the hands of investors as dividends. If the fund’s properties appreciate in value or are sold for a profit, investors will see their holdings increase in value.

Most major investment companies, including Abrdn, L&G, M&G and Scottish Widows, run commercial real estate funds. Most are focused on the UK, although a number invest abroad in Europe or the Far East.

Some invest in specific areas such as logistics (distribution centers and warehouses) and social housing, while others avoid direct real estate altogether and only invest in real estate equities.

It is also important to know that commercial vehicles are set up in two ways. First, as mutual funds where money flows in and out of investors, with the managers trying to ensure there is enough cash at all times to absorb heavy withdrawals.

Sometimes, as happened in the aftermath of the Brexit vote, they fail to do so, closing the fund until enough assets (properties) have been sold to meet all redemption requests.

The second way is as a publicly traded investment company or trust where investors can always buy and sell shares. The only downside is that the share price may not reflect the full value of the trust’s assets, causing the shares to trade at a discount.

How is the ground in the sector now?

The pandemic and shift to working from home has not been good news for UK commercial property investors. And they haven’t had an easy time since then, as property values ​​and rents have come under pressure from a strained economy and corporate failures. This has led to losses for investors.

But while there are still challenges, analysts believe it can’t get any worse – it can get better. Specifically, with respect to real estate funds listed on the UK stock market, the broad discounts they trade at offer value to long-term investors – if the discounts close and positive sentiment returns to the asset class.

Analysts from equity specialist LWinterflood think that the fall in value of commercial property in the UK is reaching its lowest point. In the last quarter of 2022, capital values ​​fell by as much as 14.6 percent, but in the three months to the end of March they fell by just 0.3 percent. Winterflood says: ‘We do not expect any further material declines in UK property valuations during the remainder of the year.’

Still, rising interest rates are forming dark clouds, driving down the capital value of commercial buildings, while income property funds are becoming relatively less attractive than more secure income alternatives such as UK government bonds (gilts).

Annabel Brodie-Smith, a director of the Association of Investment Companies, says: “In the past, brave investors who invested in real estate in challenging markets were rewarded in the long run.” She adds, “Some real estate investment companies have dividends linked to inflation, which is reassuring to investors.”

They include LXI Real Estate, Supermarket Income Real Estate, Value and Indexed Property Income, Triple Point Social Housing, Tritax Big Box, and Impact Healthcare.

Listed commercial real estate funds currently generate investor income equivalent to 7 percent annually, largely a reflection of their subdued share prices. The average share price discount for the UK commercial property trust sector is 26 per cent, compared to 6 per cent at the end of 2021.

Analysts from Winterflood say: ‘Discounts on a number of UK property funds remain extremely broad, which we believe offers value for long-term investors.’

Thirty percent discounts exist on trusts such as Abrdn Property Income, Balanced Commercial Property and UK Commercial Property Real Estate.

How can you invest in commercial real estate?

More than 100 funds are available to investors. There are 13 established as funds that invest in direct real estate and 79 that invest in shares of real estate companies or abroad. More than 20 have been set up as listed investments, most of which invest in UK commercial property.

Given the illiquid nature of real estate, listed funds are most suitable. Brodie-Smith says: “Mutual funds provide an asset manager with a permanent pool of capital that allows them to take a long-term view of their portfolio – and means they are not forced to sell shares when shareholders want their money back.

“Of course stock prices can fall dramatically in a recession, as we saw during the pandemic, but in the past they have recovered quickly when sentiment improved.”

Commercial real estate has proven to be a volatile investment and so those who choose to invest should usually do so only as a small part of a diversified portfolio, designed to be held for the long term.