18 February 2020
High street decline signals testing times in UK property
The small Scottish seaside town of Kirkcaldy 12 miles north of Edinburgh is an unlikely bellweather in the investment environment for UK property. But as dusk fell on 11 January this year the town’s Debenham’s became one of the first of the chain’s stores to close under the terms of the Company Voluntary Agreement (CVA) reached last year.
The town had already lost a BHS and Marks & Spencer stores. These are just the latest examples of a long-running trend that has seen over 400 companies, and 19,000 stores shutter in the UK high street over the last decade, creating headaches for property investors.
The outlook for some traditional UK property investment – notably in retail spaces - is gloomy. Added to that the structure of the funds themselves, compared to the underlying investments, could compound the problem.
With the risk of potential headwinds on the horizon, a key concern is that higher redemptions could increase the risk of some funds imposing 'gates' (restricting redemptions due to the inability to liquidate holdings to satisfy outflow requests). History tells us that being stuck in a fund that is managing liquidity issues can be damaging to returns.
Looking ahead, if you hold a traditional UK property fund you should be asking three questions:
- Do you only hold a single fund? If so, you may be more exposed to a damaging redemption run compared to those holding several funds.
- Does your fund allow daily dealing? The illusion of daily liquidity gives less control to managers dealing with redemptions which can increase the risk of gating (as we’ve seen with daily-priced property funds for retail investors, like M&G’s fund that suspended in December 2019).
- Are only UK pension schemes invested in the fund? Funds with better-diversified investor bases (including investors abroad attracted by weaker sterling) are often more stable.
If the answer to any of the above is ‘Yes’, it is worth taking time to consider your options.
Stick or twist?
What you do in 2020 should depend on your time horizon, your performance experience and the nature of your property allocation.
For some, it may be worth reducing your allocation - particularly if you expect to reduce exposure to growth investments in any event over the next few years. For example, a UK pension scheme with a pre-defined de-risking plan is well placed, in my view, to bank some of the strong performance experienced from property in the last 10 years.
However, if you take a longer-term growth view, and stomach the risk of some volatility, there is opportunity in maintaining exposure (especially given the high costs of moving in and out of property). With gilt yields so low, additional yield from rental income has never been more attractive. Vacancy levels are still relatively low, and unlike the 2007-crisis the market is not overburdened with unmanageable debt or too much development. If you are in for the long-haul however, it is worth considering how you are allocated, and what options are available to weather volatility if it occurs.
Single fund allocations leave open the risk of severe under-performance if there is a redemption run. Using a fund-of-funds, which holds several underlying property funds, limits the impact on returns if any one fund experiences liquidity issues. It also allows you to tap liquidity from secondary market brokers and, based on current trading, spread allocations across several funds for minimal (or in many cases no) upfront transaction costs.
Going global is another way to diversify. Accessing well-established, mature pools of global property (preferably in open-ended funds with lower gearing) reduces risk, as opportunities and returns tend to reflect idiosyncratic local issues in each region or city, rather than broad macroeconomic trends. For example, Brexit does not influence property valuations in Melbourne. Some funds allow investment at the NAV price (with transfer taxes spread within the fund) reducing upfront costs.
Focus on income
Properties with long-term contractual rental income should fare better if the market deteriorates (although will not be completely immune).
They benefit from pre-agreed rental uplifts (fixed or inflation-linked for several years), tenants with higher credit ratings or security in the structure (eg ground rents). There are several well-established funds available, although some have long queues. We are also seeing some specialists launch funds in interesting niche areas, like smaller lot size properties, social and affordable housing, shared ownership, elderly or supported living.
Lend or own?
Another option is to provide lending to the owners of these assets rather than owning directly. Real-estate backed lending is another attractive area. Backed by ‘bricks & mortar’ property, these funds deliver contractual cash-flows, and should be less exposed to a downturn than corporate lending or traditional property funds.
In the end it really comes down to your objectives and your long-term asset allocation. Now could be the time to exit if property is unlikely to be a long-term feature of your portfolio. For those who see property as a long-term part of their real asset growth portfolio - and there are good arguments behind that view - diversifying or shifting focus to stable income properties is something to bear in mind.