AEW UK Real Return Fund highlights for the quarter ending 30 September 2017:
- RRF has acquired its 30th investment
- 9.9 per cent annual total return (7.2 per cent adjusted for inflation)
- Distribution yield increased to 5.3 per cent
- Portfolio yield increased to 6 per cent
- 76 per cent of income linked to inflation
- WAULT to lease breaks over 15 years
Other than the constant whine of the Brexit debate, the backdrop to the third quarter’s economic performance has been the surprisingly strong consumer spending numbers coming off a continued rise in inflation, and the increased prospects of an interest rate rise before the year end.
The ONS has confirmed CPI for September had risen from 2.9 per cent to 3 per cent, with the consensus view seeming to expect inflation to continue with a further slight rise towards the year end; thereafter it is expected that the impact of the fall in sterling (back in 2016), and rising import costs, will have washed out of the numbers.
That retail spending has been so strong is also surprising, as wage rises have not kept up with price increases for some time and the consumer has felt increasingly squeezed. An increase in interest rates seems an increasing possibility, more so because of the need for Mark Carney to maintain his credibility and to follow through on the BoE’s forward guidance, rather than a tool to control imported, cost driven inflation.
What does rising interest rates mean for real estate?
We are watching closely the impact which rising inflation and interest rates has on the gilts curve as ultimately this will impact on the relative pricing of property. For “traditional property” we are a long way through the cycle and property fundamentals are relatively weak at this time of uncertainty. However, property is still in the advantageous position of offering one of the highest yields from traditional asset classes-the least unattractive sector, as it has recently been described. And the yield gap is relatively high. In our view, a key risk is not recognising that this is because fixed income yields are expensive and unattractive rather than property yields being cheap and that raising interest rates could see the yield gap start to close.
Income is good, but income growth is better
Nevertheless, at a time like this, property income should be defensive. The one obvious “bubble” is the competition amongst Long Income Funds who can only buy the finite supply of long, investment grade leases as a “bond proxy”; and if fixed income yields rise, the assumption has to be that either the pricing for long income falls, or risk premia get squeezed. We do however believe that in an environment of normalising interest rates, rising in response to growing economic activity, it will be real estate strategies that focus more on the underlying value of the property fundamentals that should perform well, where the quality of the asset dictates the sustainability of income, and the ability to capture income growth driven by the strength of the real economy
Yields on typical “IPD-style” assets are supportable in the current environment
However, the issue for investors in “balanced” funds is that managers typically place more importance on cyclical capital growth to outperform the relative total return benchmark, hence why the average distribution yield on the AREF/ IPD All Balanced Property Fund Index is only 2.5 per cent across all participants and 4.3 per cent for those funds which pay a distribution.
How the AEW UK Real Return strategy benefits from the current economic environment
RRF manager, Ian Mason, said, as income has consistently contributed to 70-80 per cent of UK Property market returns over the last 30 years, the RRF strategy is simple, in that:-
• It focuses on income to drive returns and property fundamentals to drive sustainable, perpetual cash flow and income growth.
• This not only protects capital invested but also underwrites capital growth which long term investors have enjoyed over the same period, despite having to suffer short term cyclical volatility in total returns.
• As RRF is not a slave to the AREF/IPD All Balanced Index, we can target strong areas of the real economy (“alternatives” in property speak) driven by non-cyclical factors such as demographics and social change to build far more sustainable and resilient cash flows, compared to portfolios dominated by benchmark weightings of traditional shops, offices and industrial.
• The focus on income should not only dampen volatility, but also provide tactical advantage when traditional IPD benchmarked strategies are out of the market. Having already built a defensive portfolio with a WAULT long enough to qualify RRF as a Long Income Fund, and with almost 80 per cent of income linked to inflation, RRF’s current strategy is to be contra cyclical, and target areas of the market where long term property fundamentals are strong, and we feel pricing overly discounts any short term perceptions of risk in these uncertain times.
It is this innovative approach to portfolio construction (still based on AEW’s proven track record in the principles of core property investing) that sets the AEW UK Return Fund apart from traditional core funds and tightly constrained Long Lease funds, the fund’s manager said.