Insight

Finding secure income amid uncertainty

November 2017

UK commercial real estate has performed well so far in 2017, recovering strongly from the uncertainty caused by last year’s EU referendum. For example, capital values are up 2.1% over the last six months according to the UK IPD Monthly Index, having turned negative in 2016. Meanwhile, rental growth has remained stable. Overseas investors have also snapped up prime UK real estate assets, enticed by sterling weakness.

In our view, this trend will continue, with strong positive returns over the full year. Into 2018, we anticipate income providing the majority of returns as the cycle enters a mature phase. This will be welcome news for investors who continue to seek a secure source of income in an environment in which interest rates and government bond yields are likely to stay low for some time.

Dynamics in the UK real estate market are also supportive and fundamentals – such as limited development, low vacancy rates and improving demand – remain robust. The occupier market also remains strong despite ongoing Brexit uncertainty, which continues to pose a risk to decision making.

Looking at individual real estate sectors, we prefer industrial assets (industrial estates and logistics warehouses). The shift by consumers towards online purchasing, which has caused a significant increase in demand for warehousing space by retail businesses, should help deliver real rental growth.

Conversely, the outlook for Central London offices is less positive. Returns from this sector were slowing pre-referendum. However, the ‘Leave’ result has brought additional uncertainty and downside risk, with businesses here most exposed to potential regulatory restrictions on European trade, which could reduce demand for office space.

Elsewhere, the retail sector requires careful consideration. Inflationary pressure may prove a significant headwind. This could mean more pronounced polarisation within the sector between ‘good’ and ‘bad’ properties (in terms of location, income length and tenant strength). Therefore, stock selection will be vital in delivering strong returns.

Recent activity within the UK Commercial Property Trust, which Standard Life Investments manages, reflects these sector views. Prior to the referendum, we sold two properties – Arlington Street in London’s West End, and Dolphin House, Sunbury. This reduced the Trust’s exposure to London offices and was in line with our view that the outlook for this sector is likely to become more challenging. The sale of 13 Great Marlborough Street, Soho, London, followed in January this year, at a yield of 3.3% and ahead of its year-end valuation.

We reinvested part of these sale proceeds in a £22.2 million forward-funding commitment to acquire an industrial distribution unit in Burton upon Trent. The unit was fully pre-let on a 15-year lease that will generate a yield on cost of 5.8%. We also bought a Grade A office building in Sheffield for £20.2 million. Again, the property is fully let on a 22-year lease with rent reviews linked to inflation. Together, the two acquisitions, at a combined £42.4 million, deliver a blended yield of 5.4%.

These transactions helped to boost portfolio performance in the first half of the year. In addition, strong asset management activity, aimed at retaining income and improving lease lengths, added value. Indeed, letting activity in the second quarter alone generated income worth £3.4 million.

Looking ahead, we believe that our efforts to increase exposure to preferred sectors and longer income leave the Trust well positioned. The portfolio comprises prime assets geared towards generating relatively secure income and a strong tenant base with good covenants. The Trust also has a robust balance sheet with low gearing and considerable resources to fund investment opportunities that would add further value. Finally, with an attractive current dividend of 4% that we believe is sustainable, the Trust offers particular appeal to investors seeking a steady income in the current low-yielding environment.