The Brexit vote just over a year ago created a significant amount of volatility in property markets. Concerns over prolonged uncertainty in the UK were offset by the sharp currency devaluation that followed, and in aggregate UK property has actually performed remarkably well over the past 12 months.
There has, however, been a notable shift of foreign investment away from the UK and into European property funds as investors anticipate an increased demand for office space if financial services companies shift their operations out of the UK. Now that the clock is ticking following the triggering of article 50, and with the UK government’s stability in question after the recent general election, headwinds to future returns would seem to have increased.
These concerns may be most acute in the London market, and notably the office sector. With potential for a significant change in the landscape of the financial sector the longer the uncertainty persists and with valuations at elevated levels, it would seem reasonable to conclude that future growth is going to be more challenging in these areas.
Within the Thomas Miller Investment Diversified Assets Fund, we have an approximate allocation of 20 per cent to property markets. While we are not overly bullish on UK commercial property markets in aggregate, we do believe that by being more targeted in our approach and accessing specific niches within markets we can drive positive performance.
Areas that we favour tend to be where we see strong fundamental support and trends that are likely to persist. Areas such as social housing and healthcare property have less sensitivity to the broader economy and are supported by the UK’s ageing population.
Demand on the occupier side for healthcare is ultimately driven by the domestic population, which will continue to need the services offered by the operators regardless of economic growth.
The logistics sector is supported by the disruption of the ongoing move to online retail. The sector will not be immune to uncertainty around the trade impacts of Brexit, but supply remains weak. Further ahead, technological change in the logistics sector will continue to influence real estate preferences. As a consequence, our focus is on these specific sub-sectors.
In terms of accessing property markets, we have a preference for using investment companies as we feel that they have a structural advantage over open-ended funds which will lead to superior long-term returns.
As was evidenced following the Brexit vote last year, while the open-ended funds claim to offer daily liquidity, due to the illiquid nature of the underlying investment they are not always able to provide it. This also confers a competitive disadvantage, namely that they have to carry a large proportion of cash in order to satisfy redemptions. In contrast, real estate investment trusts (REITs) offer geared exposure (on average 125 per cent of NAV) to property markets, thus making them a more efficient means of accessing the sector from an asset allocation perspective.
For open-ended funds, cash levels are currently particularly high, in some cases above 30 per cent. Although the present mood on this subject seems fairly relaxed, this issue was noted by the Bank of England in its twice-yearly financial stability report.
There is also an FCA discussion paper on the future of open-ended funds, and so one wonders whether these cash levels foretell upcoming imposed structural changes. We await the publication of the FCA report with interest.
While we favour more specialist areas, and accessing these through the REIT structure, a word of caution is necessary. Over the course of 2017, a significant amount of new capital has been raised in the investment trust sector, notably within infrastructure assets, but more recently we have seen a number of new entrants to the REIT sector.
This, in and of itself, is not a bad thing, and there are indeed opportunities that allow for and can therefore justify this new capital. Nonetheless, it remains imperative to ensure that the managers have the requisite skills in their specialised area and are able to deploy sufficient capital in a timely manner to provide investors with both liquidity and diversification.
Through our investment research, we continually seek to identify these opportunities and believe that, despite the overhang of potentially challenging and protracted Brexit negotiations, certain areas of the UK property market remain attractive.
Mark McKenzie is senior portfolio manager at Thomas Miller Investment