Please note that the views and opinions expressed in this article may be promotional and do not necessarily reflect those of Aviva.
In 2016, UK commercial property was grabbing headlines for all the wrong reasons.
First came tax changes – in March, Stamp Duty (SDLT) rose on purchases over £1.05m. Idiosyncratic fund pricing mechanisms then led a number of property fund prices to swing up and down. Most significantly, a swathe of funds suspended trading after the UK’s European Union referendum in June, with the prospect of falling asset prices looming large.
Despite these challenges, however, the UK commercial property market generated a positive total return (the combination of income and growth of capital) of 2.6% in 2016, according to the benchmark IPD All Property index (Source: Morningstar, Datastream, Bloomberg, 31 December 2016, return calculated in GBP).
Asset performance should not be assessed crudely on a calendar year basis, of course. Like all asset classes, commercial property has positive and negative periods and trying to time entry and exit points as an investor can be perilous, especially in a sector where transactions are not frictionless, and past performance is not a guide to future performance. Consider how lawyers, agents and stamp duty all add time and cost to buying and selling your own home. The same logic applies with commercial property, where we believe having a long-term investment horizon – say of more than five years –is critical.
So why invest in property funds?
In our opinion, owning commercial property can generate sustainable and consistent levels of income, while potentially avoiding erosion of capital over time. Relative to bonds and shares, commercial property can offer investors an attractive yield – annual returns as a percentage of their initial investment. However, as with investing in any asset class prices can fall, as well as rise, and you may not get back the original amount you invested.
The regular income distributed to investors can be secured by the quality of tenants inhabiting the underlying properties in a fund. In a well-diversified property fund, there will be a range of tenants who come from several sectors across multiple properties, providing potentially a lower risk income stream. Leases can last five to ten years, and sometimes longer, with rental growth often contractually agreed through upward-only rent reviews or fixed annual increases in line with inflation.
Investing directly in the commercial property sector will be prohibitively expensive for most individual investors, so funds can offer a cost-effective way to get direct exposure to the asset class. By pooling investors’ money, fund managers can selectively invest on behalf of their clients in the areas of the market that they find most attractive.
Furthermore, returns from UK commercial property over the past 25 years have proven to be relatively uncorrelated to other major asset classes, namely bonds and equities. This means the sector can add diversification to investors’ portfolios, helping to reduce their overall investment risk.
While property can therefore be a cornerstone in a diversified portfolio, properties carry specific risks and are relatively illiquid, in the sense that they cannot be readily sold at short notice. This can influence an asset’s pricing during periods of market stress. So, for all the benefits property can bring, investors need to manage their exposure to the sector carefully.
Is now a good time to invest?
Negotiations between the UK and the EU on the terms of ‘Brexit’ are set to begin this year, bringing fresh challenges and uncertainties for the UK economy. Property represents the roof over which the economy sits and so the sector is unlikely to be immune.
Setting ‘Brexit’ aside, the fundamentals of the commercial property market have not changed a great deal, however. Foreign and domestic money continues to be attracted by the high prospective investment yields on offer, and the postponement of development projects (ahead of ‘Brexit’) reduces the chances of supply outstripping demand in the years to come, supporting rental income. Moreover, vacancy rates across all sectors are below long-run averages and tenants seem broadly resilient, despite concerns around rising UK inflation and possible barriers to trade once the UK leaves the EU.
Factoring all this into our forecasts, M&G has estimated total annual returns of 5.5% from the UK commercial property sector for the next three years, although please keep in mind this is an estimate and therefore cannot be guaranteed. This will be driven predominately by income, with some growth in property values forecast for late 2018 and through 2019.
So long as there is such uncertainty in the UK property market, possible further weakness cannot be ruled out in certain areas. However, providing that property investing meets your investment needs, and if you are prepared to take a long-term investment view, we at M&G believe property investors could potentially be well rewarded.
The value of investments will fluctuate, which will cause fund prices to fall, as well as rise, and you may not get back the original amount you invested.
Please remember that past performance is not a guide to future performance.
The views expressed in this article should not be taken as a recommendation, advice or forecast. M&G is not able to give any financial advice. If you’re at all unsure about the suitability of your investment, please speak to a financial adviser.
This financial promotion is issued by M&G Securities Limited which is authorised and regulated by the Financial Conduct Authority in the UK and provides ISAs and other investment products. The company’s registered office is Laurence Pountney Hill, London EC4R 0HH. Registered in England No. 90776.