We suggested at the start of 2023 that commercial property stocks could prove to be a good bet this year, with valuations offering significant upward reversion potential from their depressed levels and dividend yields at the top end of their historic range.

While valuations have improved slightly, if anything sentiment is even more negative than it was in January, especially after April’s stubbornly high inflation data which sparked fears the Bank of England may have to hike interest rates further to rein in prices.

Yet, at an operational level, the picture couldn’t be more different, with half a dozen managers telling Shares that the UK commercial property market is in good shape.

We think that for investors who can afford to look past the current disparity between the fall in net asset values and the strength of the market ‘on the ground’, the rewards in terms of upside potential and inflation-matching yields are substantial although not entirely risk-free.

HAVE VALUATIONS BOTTOMED?

One of the problems troubling the commercial property sector in the last six months is a sharp fall in transactions, which means a lack of ‘price discovery’.

Usually, the UK market is quite active with buyers from the private equity world, family offices, pensions funds and so on vying to get their hands on real assets with long-term income streams.

However, the ‘mini-Budget’ last autumn together with the continued rise in inflation and Bank of England base rates has led many professional investors to take a step back, with the result that there are few transactions on which to base valuations.

Yet according to the CBRE monthly index, capital values eked out a 0.6% increase across all UK commercial property in March, after months of declines, with industrial property values rising 1.3% and retail values rising 1.1% while office values slipped 0.3%.

At the same time, rental values rose 0.5%, with industrial rents up an average of 0.9% and retail and offices up 0.1%, meaning the total return for the sector was 1.1%.

Moreover, according to Emma Bird, head of research at Winterflood Securities, after a heavy sell-off in March, ‘the vast majority of property investment trusts saw positive share price total returns in April’ with standout performances from Life Science REIT (LABS), which saw its discount to net asset value come down from 33% to 22%, and Tritax Big Box REIT (BBOX) where the discount narrowed from 26% to 18%.

Even so, 21 out of 34 property investments trusts were still down on the year coming into May in share price total return terms, says Bird.

WHY ARE INVESTORS WORRIED?

There are a number of reasons why investors are still pessimistic on the UK commercial property market, from changes in office working habits to falling net asset values and potentially more expensive debt costs from higher interest rates.

We will look at the office market later in this article, but as Mark Allan, chief executive of Land Securities (LAND), one of the UK’s biggest listed property companies and a FTSE 100 constituent, said in May, the past year has seen ‘the most striking difference in performance between occupational markets and investment markets that I can remember.’

Allan added: ‘In investment markets, rapidly rising interest rates led to a sharp slowdown in transaction activity and falling asset values, whereas from a customer perspective, strong demand for Landsec’s best-in-class space drove consistently strong leasing, rising occupancy levels and growing rents across all parts of our portfolio.’

That, in a nutshell, is what investors should be paying attention to – not whether valuations are rising or falling, but whether rents, and by extension earnings, are rising or falling, because at the end of the day it is earnings not valuations which pay their dividends.

Moreover, no chief executive or management team, regardless of how talented they are, can control interest rates or their effect on property values.

What they can and have done in the past year is ‘control the controllable’, namely raise rents on renewals and new leases, keep a lid on costs and review their portfolios, selling off mature assets at a premium to their estimated rental value and buying more attractive assets with greater income potential.

As Andrew Jones, chief executive of logistics specialist Londonmetric (LMP) told Shares, the company’s results for the year to February 2022 included a £630 million upward revaluation of the portfolio, whereas in March this year the portfolio was devalued by around £590 million, yet he and his team have done ‘exactly what we always do, generate reliable, repeatable and growing income.’

Admittedly, it takes a brave investor to look through the negativity and the fall in asset values, and there remain risks which are outside the property companies’ control, but there are several important structural trends driving demand for high-quality commercial space in the UK and which are here for the foreseeable future.

BOXING CLEVER IN LOGISTICS

One of the sub-sectors of the commercial property market which saw the biggest overvaluation in recent years was large-scale logistics warehouses, where rental yields fell to as low as 3% to 4% before interest rates started rising and valuations began to normalise.

Due a shortage of capacity and low interest rates, which encouraged private equity firms and other big investors to overpay for physical assets with secure, long-term yields, prices for ‘big box’ warehouses went through the roof during 2021 and early 2022.

However, the invasion of Ukraine burst the bubble as suddenly supply chains – which were already creaking due to the seismic uplift in e-commerce demand triggered by the pandemic – almost ground to a halt.

Suddenly, big boxes were no longer flavour of the month, and as companies rushed to reinforce their supply chains and the world turned to ‘near-shoring’, mid-sized logistics assets became the focus.

Every property firm involved with logistics assets interviewed by Shares for this article said the same thing – due to the lack of high-quality space in good locations, valuations and rental values are only going up.

LondonMetric has been steadily rotating out of large warehouses over the last five years and in 2022 cut its exposure to just 10% while increasing its exposure instead to urban logistics assets – which make up 43% of the portfolio – due to their greater potential for rental growth.

That being said, in its May trading update Tritax Big Box reported ‘continued strength in occupier demand’ for large warehouses and take-up of 6.6 million square feet of space in the first quarter of 2023, in line with its five-year average.

Moreover, the firm ratcheted up prime rents by another 2% to 3%, added £4.1 million to its annual rent roll and took advantage of the dislocation in prices to snap up around £60 million of high-quality urban logistics assets with significant near-term reversionary potential, according to chief executive Colin Godfrey.

The fact remains that, from big-box to multi-let estates, the logistics sector is still underserved in the UK in terms of high-quality, well-located, efficient properties, and rents – which are typically inflation-linked anyway – are just going to keep rising.

‘OFFICE MARKET NOT DEAD’ SHOCK

Despite the post-pandemic move towards ‘hybrid’ or flexible working, the idea that the office is dead is a long way from the reality of most peoples’ lives.

Every office specialist interviewed by Shares, both in London and the regions, has seen rising occupancy rates and rents this year, especially in areas which are well-connected and well-located.

The simple fact is, firms want their people – usually their biggest asset – back in the office, and in order to do that they have to make the office a lot more appealing than it was pre-Covid.

‘London is still a leading world city,’ says Gerald Kaye, chief executive of office specialist Helical (HLCL), ‘and barring some economic or geopolitical catastrophe there will be ongoing demand for best-in-class office buildings from occupiers who need well-located, highly sustainable offices with good amenities, which are essential in attracting and retaining the top talent.

‘There is a real shortage of best-in-class newly refurbished or redeveloped office space in central London, meaning landlords can command premium rents, and this dynamic is likely to persist for the rest of this decade as the market plays catch-up,’ adds Kaye.

Philip Hobley, head of London offices at agent Knight Frank, believes rents in core London areas like Mayfair and the West End could break the £200 per square foot barrier, and points to the decision by Blackstone, the world’s largest alternative asset manager, to move into a newly constructed purpose-built 10-storey headquarters on the south side of Berkeley Square as a sign of things to come.

Knight Frank estimates that based on current take-up rates there will be a ‘structural undersupply’ of 9 million square feet in London by 2027, which means rents will inevitably go up.

Admittedly, activity in London may not be representative of what is happening in the rest of the UK but journeys on public transport are up across the board and most surveys show offices are full at least three days a week.

Richard Shepherd-Cross, managing director of Custodian Property Income REIT (CREI), argues the UK commercial property market is in as good a place as it’s been for many years.

Custodian specialises in regional assets, ranging from offices to multi-let industrial, retail and drive-throughs, and Shepherd-Cross puts the firm’s success down to its active portfolio management.

‘There is a lot of talk of a divergence between prime and stranded assets, in other words older, less amenable offices in less attractive locations, but all it takes is an active approach and some imagination.’

Shepherd-Cross points to a mature office site in Manchester which was previously rented at £20 per square foot but has since been refurbished with meeting rooms, a coffee bar and a gym, and is now let at £35 per square foot, easily recouping the firm’s investment.

Meanwhile, offices located on retail parks are being redeveloped as urban logistics centres to take advantage of the surge in demand and vacancy rates in the low single-digits.

INSIDERS ARE BUYING

According to consultancy Carter Jonas, investment in UK commercial property fell for the fourth consecutive quarter in the three months to March to £7.7 billion, 26% below the previous three months, 43% below the five-year average and the weakest quarter for more than a decade.

Overseas investment fell 75% quarter-on-quarter and 81% year-on-year, marking the lowest quarter since the start of 2012.

Yet despite the lack of investment activity, it is clear from speaking to property firms that for those who are well-connected there is still an active market in industrial and logistics assets and an active approach can pay dividends.

Laura Elkin, manager of AEW UK REIT (AEWU), confirms there is plenty of competition for industrial assets and flags rising interest from owner-occupiers.

The firm recently sold around 100,000 square feet of space on Deeside Industrial Estate to an owner-occupier for £4.75 million, netting a 10% gain on the purchase price and bolstering its reserves to spend on higher-yielding assets while at the same time avoiding having to spend £1 million on refurbishment.

Moreover, there have been a couple takeovers so far this year with both buyers paying a healthy premium to market values which suggests the smart money knows these depressed valuations won’t be around forever.

At the beginning of April, multi-let property firm Industrials REIT (MLI) received a bid from Blackstone at a 42% premium to its undisturbed price after posting 10 consecutive quarters of 20%-plus average uplifts in passing rents, demonstrating the reversionary potential of its portfolio.

LondonMetric recently announced it is buying CT Property Trust (CTPT) at a 34% premium to the target’s undisturbed share price, which still represented a mid-single-digit discount to CT’s last reported net asset value per share.

ARE DIVIDENDS SAFE?

Income is a key part of the investment appeal for property investors, and REITs are required to pay out 90% of their property income in dividends or a ‘property income distribution’ as it is known.

Which raises the question, if UK inflation is proving stickier than hoped and financial markets are now pencilling in up to another one percentage point interest rate rise from the Bank of England by the end of the year, taking base rates to 5.5%, what does it mean for dividends given property companies have debt which they need to service?

Analysts Matthew Saperia and James Carswell at Peel Hunt have asked exactly that question in a recent note, and their conclusion is, ‘With prudent leverage, risk-averse funding and good rental growth prospects, the sector is well placed to absorb the long-term move to higher interest rates.’

Property companies paid out £2.3 billion to investors last year, with dividend cover ‘healthy’ at over 1.2 times across the companies under Peel Hunt’s coverage.

The analysts believe that despite a rise in debt service costs of around 20% from 2021 to 2024 and a similar increase in administration costs, there is no reason why dividends shouldn’t just be maintained but grow annually by 9% on average this year and next year.

Indeed, amongst the firms which Shares interviewed for this article, the vast majority had already renegotiated lower coupons on their debt well before the Bank of England began raising rates, in anticipation of tighter funding, and had extended the average maturity of their debt.

WHERE SHOULD YOU INVEST?

For those who want to keep it simple and stick to large-cap stocks it is hard to ignore Land Securities, which has a top-quality portfolio of central London assets, a rock-solid balance sheet, a dividend yield of more than 6% (more than 1.2 times covered by earnings) and good potential to increase rents.

For those with a greater risk appetite or a need for more income, Regional REIT (RGL) – managed by London & Scottish and Tosca Asset Management – has a geographically-diversified UK office portfolio and aims to generate a greater than 10% total annual return for shareholders.

While it has a higher level of gearing than other firms, its shares currently yield more than 12% meaning investors are being paid a substantial premium to the sector average.

For investors seeking a broad spread of commercial property assets and an attractive yield, AEW UK REIT owns a mix of industrial, warehouse, retail and leisure assets across England and Wales, and its shares yield just over 8% at the current price.

Disclaimer: The author owns shares in AEW UK REIT and Regional REIT

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