Is property still a worthwhile income and diversification tool?

Commercial property investments can provide an attractive and hopefully rising rental income and some capital growth over the long term.

| 8 min read

Following on from my articles on infrastructure assets, another portfolio diversification tool to consider is property.

Commercial property investments can provide an attractive and hopefully rising rental income and some capital growth over the long term – potentially outpacing inflation. Areas with overcapacity are less likely to make good inflation hedges, though. Falling rents or void periods reduce investor income and hinder capital values. Other areas in demand such as warehouses, logistics, data centres and healthcare property could be more resilient, albeit valuations are more expensive, and rising income streams from strong performing property assets could be a valuable addition to an income portfolio.

For investors that don’t need an income, property can still be a useful asset. It has its own drivers of performance, although broader market trends can have an influence. Demand for most income-producing investments can be affected by bond yields, and the economic cycle, which drives equities, can also be a factor that affects property of various types.

Recent property trends

Despite a robust and broad recovery in property funds and real estate investment trusts (REITs) since Covid lows income yields are still comparatively high. Broad-based commercial property investment trusts offer in the region of 4-5%, which compares favourably to equities and (especially) bonds. Please note all yields are variable and not guaranteed.

The high income on offer reflects lingering uncertainty as to the trajectory of rents, particularly in more troubled sectors and areas, and the capital expenditure necessary to upgrade properties or convert to alternative uses as and when necessary.

Less income is available in specialist areas seen by investors as more ‘futureproofed’ such as warehouses, logistics and certain other subsectors such as healthcare. Here, where there is greater perceived certainty, investors are willing to accept income in the region of 3% as capital values have risen strongly over the past year or so. In the lower yielding areas, there is also usually more capacity for growth in income over time; so, investors should not simply go for the highest income areas as a better return over the long term might be achieved by having a more balanced approach.

Across various property subsectors we are seeing a redefining of what constitutes a ‘prime’ property. This was probably always going to happen but, as with many things, Covid-19 has acted as an accelerant of the prevailing trend and a disruptor of the natural order. Most obviously, lockdowns sped up the migration to online retail, intensifying demand for warehouse space to execute transactions and pushing up valuations of logistically important commercial properties.

The other side of that coin has been the continued movement away from in-store retail, adding to the falls in rents and the increase in unwanted space, which was already emerging prior to the virus taking over our lives. It may be that, ultimately, as much as 20-30% of retail space needs to be repurposed in order to adjust to a new level of post-Covid demand. Owners of less viable retail sites will look to convert to residential, office or services use or consider demolition and redevelopment – which in some cases is the only option as useful conversion isn’t viable.

The property market remains incredibly varied, though, and while a net reduction in floor space requirements seems inevitable in some sectors, it will likely have a bigger impact on ‘secondary’ buildings. Certain shopping centres and high streets could continue to recover and perform well with the right offering. This is true of the office market too as increasingly companies seek workspace with less employee density – smaller, flexible and high-quality spaces are sought after.

There will also be demand for more space that meets tougher environmental targets, at the expense of older buildings that have not been extensively refitted with appropriate heating and cooling systems and proper insulation. Large company tenants often want space which will help them hit increasingly exacting green targets and are willing to pay a premium. New space is built to higher standards and advertised as “employee friendly” as well as “net-zero compliant”. All this comes with a cost, driving a two-tier market of high-grade buildings and a lower tier of less-modernised space that at some point will necessitate investment.

Ways to invest

The key to successful property investment in a portfolio is diversification. UK property funds and trusts are diversified across various property types: retail, office, industrial and so on. The ability to harness resilient income from multiple sources both conventional and specialist can create a more reliable overall income stream. However, it is also important to be selective. Being able to target the areas where rental income growth is robust and having the agility to move in and out of subsectors according to how valuations move could be an important advantage. The market is likely to be more heterogenous and fast moving than ever so a nimble go-anywhere fund could have an edge.

One option identified by our Collectives Research Team for broad exposure to the sector is TR Property, an investment trust that holds a portfolio of real estate investment trusts and property companies across Europe. In addition, it has a small level of direct UK property exposure i.e., physical property rather than shares. The manager has continued to prove himself adept at staying away from the most troubled areas and it offers high quality, diverse exposure to the asset class with a bias towards logistics, healthcare and residential.

For a generalist and diversified approach to direct property exposure, one option is LXi REIT, which is an interesting mix of resilient sub-sectors and a model that involves longer leases. Meanwhile, SLI Property Income Trust offers good value trading on a near-20% discount to net asset value currently and offers a high yield. Further recovery from the pandemic could play into the portfolio’s hands, given its greater focus on ‘secondary’ assets. Returns also stand to be boosted by gearing (borrowing to invest) which exaggerates returns from the underlying assets.

Tritax Big Box and Warehouse REIT are two logistics trusts that have thus far proven fit for the digital age, though we don’t consider them cheap having had a phenomenal past year. Returns have been powered by resilient rent collection, robust rental growth, accretive developments and ultimately valuation uplifts as UK industrial assets go from strength to strength. Given the trusts are now trading at or near historically wide premiums to net asset value, expectations probably need to be tempered from here. Warehouse REIT has the higher yield but is also higher risk as it uses gearing.

In our view, investment trusts like these provide a better route to the asset class (in respect of direct property) than open ended funds, most of which have suffered liquidity issues and dealing suspensions during volatile episodes in markets such as the Brexit vote and the onset of the pandemic. Investment Trusts have a fixed rather than variable pool of assets meaning managers are not forced to buy and sell property, and incur the high fees involved, according to the ebb and flow of investor demand. However, although shares in trusts can be bought and sold at any time, prices can be volatile, especially during a general share market sell off and where Trusts use gearing.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

Is property still a worthwhile income and diversification tool?

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