By Eugene Dimitriou, Head of Insurance Solutions, Threadneedle Asset Management Ltd
The old adage suggests that there isn’t anything safer than bricks and mortar and it is certainly true that UK property yields have held their own in recent years. From the start of the century until now, almost three-quarters (74%) of the returns from UK property investment have come from the income generation as opposed to capital gains. Whilst the capital value of property has fallen over some periods it has been cushioned by the income return which underscores why property works for long-term institutional investors such as insurers.
Indeed a decade ago, property had a similar yield to today but so did competing investments like government bonds. As bond yields have collapsed in the interim, property yields offer closer to 10 times the income of government bonds. With a further rate cut being mooted in the UK and several countries providing clear precedents of negative interest rates, that multiple might well grow before it contracts.
This in turn serves to highlight why investing in property makes sense now. The high yield on property provides a strong underpin for valuation and suggests that a crash is unlikely. Consider for example that a typical lease on commercial property will be for seven years and often considerably longer. Some will also have “upwards only” resets based on inflation as well. Equally, post credit crunch the commercial property sector has become far less vulnerable to high Loan to Value lending whose potential withdrawal may be a source of concern.
The EU referendum has clearly created an element of uncertainty in the market and caused many to question whether property remains a viable investment opportunity. We believe that the initial panic we saw was a market overreaction. There was a huge emotional component to the referendum and property suffered because it’s such a tangible investment. Investors need to look at the fundamentals which in the case of property funds mean tenants who aren’t going anywhere. Do we have a reasonable entry point into the asset class today?
The case for investing today
In times like these, a well-diversified portfolio is key. Instead of making a few large investments, one should seek smaller lot sizes, renting property to many different tenants, thus spreading the risk. This is especially important as businesses come to terms with what the Brexit vote will mean for them.
Overall, vacancy rates are at their lowest since 1980, and developers’ response to this is now likely to be more muted. For property fund managers a keen focus is the mundane task of collecting income from tenants as efficiently as possible which ensures that investors receive the income they expect in a timely manner.
Another feature that should reduce funds’ risks following Brexit is avoiding “trophy” properties in London. These properties are expensive to run and can act as a bellwether for sentiment in times of uncertainty. That can make them difficult to sell in a downturn, especially while doubts persist about the City of London’s future as a financial centre. Becoming a forced seller is an investor’s worst nightmare – especially in large size.
So what about Insurers?
In the main, insurers are no different to other institutional investors. However, as described above, the treatment of property is quite clear under Solvency II and the yield and capital advantages are clear. As the vast majority of liabilities are in Sterling, the asset class is also well sheltered from currency movements and the punitive capital costs of FX risk.
At the margin insurers are trying to be cleverer vis-a-vis management of liquidity. As their long dated liabilities are arguably amongst the most stable and illiquid in any economy, it stands to reason that more illiquid assets such as property should form a reasonable proportion of any yield seeking portfolio. For generations property has been a steady performer in most insurers’ with profits and staff pension funds. In the recent past we have also seen motor insurers start to use property to back Periodic Payment Obligations.
Another reason why insurers are drawn to UK commercial property is the country’s historically strong legal system which provides investors with certainty of possession. This provides peace of mind for investors, but also reinforces why the UK commercial property market retains an edge over foreign commercial investment and continues to see institutional inflows.
With Article 50 still to be triggered and the exact terms of Britain’s exit from the European Union still to be negotiated, it is clear that investors face some uncertainty. In times such as these two fundamental principles of investment – diversification and the importance of income – come to the fore. UK property ought to score well on both metrics.
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