A Fund managed by Swiss Life Asset Managers UK Limited
A Fund managed by Swiss Life Asset Managers UK Limited
Property Investment Market
Capital values for all UK property have fallen 20.4% from their peak at the end of Q2 2022 (MSCI Quarterly Index – Sep-2023). Most of these falls (-17.5%) took place during Q4 2022 following the infamous Liz Truss “Mini-Budget” on 23 September 2023, which caused turmoil in the financial markets and a spike in gilt yields. After the initial shock to real estate markets, capital value reductions moderated in the New Year and there was a brief recovery in the Spring before values started to reduce again in the Summer.
The reason for more recent capital value falls is due to continued and accelerated value reductions in the office sector. Valuations for other sectors have remained generally stable with industrials, buoyed by positive rental growth, rising in aggregate by 2.4% since the end of February. The pricing of offices is challenged at a time when investors grapple with the implications of continued low levels of staff occupation and the cost of meeting legislated energy efficiency and decarbonisation targets.
The current point in the market arguably represents the start of a new cycle, with the difficulties over the past year reflecting the painful adjustment away from a long period of ultra-low interest rates. The UK market has seen a swifter, sharper correction than other international markets, and this represents an opportunity for early movers to find value. With a stabilisation in interest rates and two calendar years of poor absolute returns behind us, we are anticipating investment activity to pick up in 2024. Refinancing pressures are expected to compel some owners to sell good quality assets, which will help revive investment volumes from their current low levels.
We strongly believe that investing in markets that are positively aligned to secular trends will provide the best prospects for income preservation and growth. For this reason, we expect investment performance will remain divergent, with continued strong performance from industrials and living sectors, weak performance from offices overall, and retail performance split between positive contributions from non-discretionary and discount formats and weaker performance elsewhere.
Occupational Market
Despite these capital market impacts, tenant demand has remained resilient. From a supply/demand perspective, the fundamentals appear robust for high quality assets positively aligned to secular trends. This continued resilience will depend on the strength of the economy and the confidence that this provides companies to grow and expand their operations.
So far we are yet to see a noticeable weakening of demand across our portfolios, however,we expect tenants to become more discerning about their occupational choices. This will hasten the evolution of property investment towards a more service orientated approach, which will require investors to be more focused on their occupiers – and to embrace them as customers, not tenants.
As a result, property is becoming increasingly operational, where the level of service and occupier experience will determine income resilience and growth, rather than long lease contracts. We are seeing this approach reap rewards in most residential formats and other niche areas of the market such as self-storage. We expect operational real estate formats to become increasingly mainstream as exposure to more traditional sectors such as offices and discretionary retail, shopping centres and high street shops, reduce across institutional investor property portfolio allocations.
PITCH
PITCH has seen a recovery in returns in 2023 led by the Fund’s strong income return and positive capital contributions from its warehouse and residential holdings, which make up around half of portfolio value. The warehouse holdings have grown by 2% during 2023 while the residential portfolio is up 4% on a like-for-like basis since the first acquisition in June 2022. The Fund has returned 1.4% in the nine months to 30 September 2023, which is comfortably ahead of the -0.3% return from the MSCI/AREF UK All Balanced Open-Ended Funds Index.
Annual income has grown by 11% compared to the previous 12 month period thanks to a successful period of leasing activity and rent reviews, which has added some £2m of new rental income from a total of 27 transactions. In many cases we were able to grow rents in excess of inflation over a corresponding five year period, which endorses our investment strategy of owning property aligned to structural tailwinds combined with an active management approach.
Consistent with the market, the Fund’s office assets have not been immune from the wider challenges being felt across the sector, however, this has been our most actively managed part of the portfolio. Over the past 3-4 years we have undertaken seven major refurbishments to improve occupational amenity and enhance EPC certifications, resulting in seven significant lettings. Over 75% of the offices are now rated EPC A-B while the total occupancy rate stands at 94%, testament to our positive occupier engagement. Concurrently, we have taken the opportunity to reduce our exposure to offices generally by selling down weaker specified offices with a total of five sales over the past two years. A further 1-2 office sales are expected over the coming few months, resulting in a target allocation of 20-25% of portfolio value.
We have been satisfied with the performance of the Fund’s residential strategy which has grown to over £20m across six different locations. Not only has it been one of the most resilient sectors for the Fund over the past 12 months it has exceed income expectations with a current occupancy rate of 96%, a net yield ahead of target and current annual rental growth of 5.8%. The outlook for the sector remains positive due to strong demand/supply fundamentals to support robust peformance over the medium to long term.
Market Outlook
Property markets are dynamic. In a fast-moving world, where occupational trends have either accelerated or been challenged by the pandemic, a proactive management approach is required to ensure long term portfolio resilience. In a higher gilt yield environment, the case for property being a bond-proxy is no longer compelling and we would question the continued relevance of a passive asset management approach that many managers follow. Buying property on long leases to tenants with a strong credit rating will not be enough to deliver attractive returns. A clear focus on the underlying real estate fundamentals and an active management approach will ultimately be the drivers of long term performance.
We acknowledge the economy remains fragile and there are risks out there that are not in our control, but property for its resilient income and diversification benefits, as part of an endowment’s investment portfolio, requires a long-term commitment.
Accordingly, current market uncertainty presents opportunities for considered and patient investors. Investors should remain unstintingly focussed on real estate fundamentals – with all investment decision-making determined by the current and anticipated requirements of occupiers.
We expect income will be the main driver of property returns in 2024 and, in a higher interest rate environment, income growth will be required to boost performance. In the last 10 years PITCH has delivered an annualised return of 6.9%, of which over 80% is derived from its distributed income, considerably outperforming the MSCI/AREF UK All Balanced Open-Ended Funds Index. It is this continued focus on income through active management that will enable us to continue to deliver attractive, long term returns to charities in a changing world.