Is property turning a corner?

Property has been a tough place to be invested. Rising interest rates have been a significant headwind, while the retail and office markets have faced ongoing uncertainty. However, as interest rates have peaked, and inflationary pressures have ebbed, there have been tentative signs of a turnaround for the sector. Should investors be taking notice?

Commercial property investments have been at the mercy of interest rate expectations for much of the past two years. This has seen property assets rally significantly on anticipation of rate cuts, but also slide every time a rogue inflation report spooked investors. Alongside China and commodities, it remains one of a few asset classes that is still below its level six months ago*.

The question for investors now is whether it is cheap – and therefore poised to rally – or there are still structural problems that leave it vulnerable. Certainly, there are pockets of weakness. For example, there are ongoing concerns over office properties and the extent to which the work from home trend will dent demand.

The picture is nuanced, varying considerably from country to country and from region to region. Marcus Phayre-Mudge, manager of TR Property Investment Trust, points out that in countries where the choice is between an air-conditioned office and a small, hot apartment, workers are still going to the office. Where the choice is a lengthy and difficult commute to an unwelcoming cubicle, workers are staying at home.

He estimates that the work from home trend has reduced demand for office space by 10-15%. While this is largely reflected in valuations, there are still regional offices in second and third tier cities where there have been few transactions and prices may have further to fall as valuers catch up with reality.

‘Brown’ buildings

‘Brown’ buildings are another problem. These are buildings where owners need to spend significant capital to bring them up to environmental standards. There is a danger that these buildings will become ‘stranded assets’, with no buyers and no-one willing to rent them. This is particularly true in lower quality areas where rents are too low to support significant capital investment. Marcus says: “I can’t understand why regional offices aren’t falling faster. Upgrades are a greater share of earnings and affect the overall value.”

However, these are only pockets of the market and the remainder looks to be through the worst. For fund managers with sufficient flexibility to swerve these difficult areas, the outlook is increasingly buoyant. TR Property currently has gearing of around 12%** (out of a minimum of -20% and maximum of +20%), suggesting real optimism on the market from here.

Marcus attributes this bullishness to four key factors: the cost of money (interest rates) is no longer rising; indexation in rental income is still coming through; beyond the ‘distressed’ areas, there is still rental growth – in particular, demand exceeds supply for best-in-class ESG-friendly assets in the office market, which is pushing rents up to new highs. There is also a range of businesses still restructuring post-Covid, creating new demand.

He is encouraged by how quickly some assets rallied as interest rate expectations shifted. “These assets were unloved, under-owned and heavily shorted.” There were a lot of technical factors, such as flows away from property into fixed income, that had been hurting the market, and reversed quickly as sentiment changed.

Merger and acquisition

Merger and acquisition activity is also important in the sector. This past year has seen a number of mergers complete, with potential deals also in the works between Tritax Big Box REIT and UK Commercial Property REIT, and Custodian Property Income REIT and abrdn Property Income Trust. M&A has the potential to produce economies of scale for investors, narrowing discounts and putting a floor under asset prices. It also proves there is a market for these assets if they get too cheap.

Marcus says that NAVs become unreliable during market inflection points. The market is looking forward, while valuers are looking back. The market has seen relatively few transactions, which also makes predictions difficult. He adds: “In our view, this is not a metric that investors should be focusing on today. Rather, they should be looking at the earnings of property companies. This leads me to be positive.” His view is that unlike private equity, the real estate market has largely had its pain.

However, he draws one important distinction. There is a difference between physical property and property companies listed on the stock exchange: “Equity markets have seen a correction, in a way that physical property hasn’t.” Valuers can be slow to catch up, whereas valuations in the stock market change instantly. “Valuers are driving in fog when there are no market transactions. They are going to be behind the curve,” he adds.

Settling down

Nevertheless, we retain one physical property fund, the TIME:Commercial Long Income fund. It invests directly in properties that have long leases to tenants across sectors within commercial real estate including supermarkets, leisure, healthcare, and hotels. It avoids more volatile sectors such as high street retail and shopping centres and has been a ‘slow and steady’ option for investors.

Manager Roger Skeldon is also optimistic. He says: “We are seeing a settling down in certain factors. Transaction levels in the real estate market were very low in 2023 but activity is expected to return to a more normalised state during 2024, as further clarity on factors such as interest rate levels become visible and confidence increases around real estate. The fund will benefit from an increasing income return through its rent reviews or indeed this could translate into capital value growth if property yields continue to stabilise.**”

TR Property, its open-ended sister fund CT European Real Estate Securities, and the TIME:Commercial Long Income fund are focused on quality property, which means they can swerve the problem areas, and uncover areas with the potential for growth in income and capital. 

There has been a lot of disruption in the commercial property sector over the past few years, but by nature it is not a volatile sector. In normal circumstances, it should be a steady option for investors, delivering inflation-adjusted income, plus a sprinkling of capital growth. It feels as if the market is closer to this point today than it has been for some time. 

Marcus says this is an interesting point in the cycle: “It will not be plain sailing and there are companies that we would want to avoid. There will be bumps in the road for some sub-sectors, but the risk is now to the upside.”

*Source: FE fundinfo, data at 10 March 2024

**Source: fund factsheet, 31 January 2024