Strong Foundations or Unsteady Ground?

Over the last year, shares from global, developed markets have produced a good return for investors; many have been surprised to see that returns have been better than the interest earned from cash.

However, many people have reduced risk by diversifying their portfolios to include asset classes, other than global shares and cash. Many of these asset classes have not produced good returns and it’s fair to ask if they should continue to be part of a portfolio. Last week, we looked at emerging markets shares. This time, we consider UK commercial property.

Commercial property has long been recognised as one of the major asset classes, producing a good return for investors, in a different way to shares and fixed interest stock. Businesses and the government need space and, of course, letting property to them is a different way of securing a return from them than lending them money or investing in their shares. The returns are also quite different to residential property, with different factors at play. Commercial property has been less popular with investors over the years, as the cost of property is too high for most to be able to invest directly, and there are only a small number of investment funds available.

As with any other asset class, the values of commercial properties will depend on the demand for them and supply of them. Supply of properties tends to be fairly static, so demand tends to have the greater influence. In the last couple of decades, there’s been a huge change in the demand for High Street retail property, as a result of the rise of out of town shopping and online retail, and this has had an obvious impact. It’s true that the decline in retail property demand has been going on for at least a century (how many people have addresses of “The Old Forge” or “The Old Post Office”? I don’t think the “Old Wilko” has quite the same ring though!). At the same time, of course, the demand for warehouses (to fulfil online demand) has increased.

Retail property is only one part of the commercial property market, and investment fund managers have tended to have low allocations to it. Industrial property, offices, warehouse, and other assets, like hotels and student accommodation, make up the majority of most investment funds.

Demand for industrial property and warehouses has remained strong, and the move away from globalisation should help this to continue. It’s more difficult to second guess the office market, as there have undeniably been changes in the way in which we work; this change seems to be having a greater effect on businesses associated with offices, such as sandwich shops, than on the demand for offices themselves.

In the meantime, property managers are reporting high levels of occupancy for their properties, and they have been able to increase rents for existing tenants over the last couple of years. Typical income yields on property portfolios are around the 5% mark, comparing favourably with other asset classes.

Despite this, commercial property values have been marked down for the last few years, and this has, of course, affected people’s sentiment towards the asset class. Property values were first affected by COVID lockdowns, and then by the subsequent rises in interest rates. Rising interest rates affect the sector in two ways – firstly, the income produced by property rental becomes less attractive than leaving the money in the bank, and, secondly, there is a lot of debt in the commercial property market and a rise in interest rates reduces profitability for the sector as a whole, as interest payments eat more into the profits from rents.

Over the last few years, the FCA has been conducting an investigation into illiquid assets and their inclusion in funds available to retail investors. Illiquid assets are investments which cannot be sold quickly, and commercial property falls into this asset class. This lack of certainty has been one of the reasons cited for closure of some funds in recent years, and it would be disappointing if this asset class ceases to be available to the ordinary investor.

Our investors have low weightings towards UK commercial property (around 5% of their portfolios, typically), and this reflects our caution towards the asset class. However, the asset class had a total value of around £1.35 trillion at the end of 2022 (source: Statista), compared to the £2.2 trillion value of the UK stockmarket (source: London Stock Exchange), so it would be unusual to ignore it completely.

A period of flat or reducing interest rates in the UK would have a positive effect on valuations, as would a continuation of the trend away from de-globalisation. It’s hard to imagine that High Street retail property valuations can go much lower, and the outlook for many parts of the market, such as warehouses and industrial property, remains good. It does seem likely that the negativity towards offices has been exaggerated; my view is that businesses that are dependant on footfall from offices are more likely to suffer than the landlords of those offices.

Commercial property does remain an asset class where patience may be rewarded. Sentiment tends to move more slowly in the market, as, unlike the stockmarket, purchases and sales don’t occur often and there are only a few valuers in the market, and they generally take an understandably cautious stance. In the long run, we recommend that some investors retain some exposure to this asset class, despite returns having disappointed in the last couple of years.

Philip Wise |

Managing Director and Chartered Financial Planner

This guide is for information purposes and does not constitute financial advice, which should be based on your individual circumstances.
The value of investments may go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.  

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