16 October 2020
In this blog Lia Licietis discusses the shorter and longer term threats to the UK property market and questions whether you should be broadening the investments for your real assets allocation.
Whilst coronavirus had us locked up at home, it also had property investors locked into their funds. Many property funds suspended trading in March 2020 with property market transactions grinding to a halt and valuers unable to place a reliable market value on properties.
Seven months later, the market is re-opening and we are seeing suspensions lift. So, this prompts the question: is now the right time to review your property allocation?
Is it back to business as usual?
Although lockdown restrictions have eased in some areas for now, fallout from the measures taken to combat the virus may continue to impact property in the years to come, accelerating structural trends in the ways we use commercial real estate.
In the immediate term the government has been working hard to mitigate the potentially disastrous impacts of coronavirus. Whilst government policies may help the wider economy, they risk playing havoc for landlords in the months ahead, through missing rent or tenants going bust once government support is withdrawn.
Longer term there are challenges ahead for offices and retail which combined make up around half of the UK property funds that are popular with pension schemes.
- Lockdown has shown that people can work from home productively. This could mean more flexible working in the future and lower requirements for office space. The UK property market will need to adapt to changes in demand for office space, while, for now, still factoring in the needs of staff to work safely within social distancing guidelines.
- Online shopping is on the rise and the need for physical shops is falling rapidly. This has only been accelerated by the pandemic. Property owners may want to consider alternative uses for their retail assets to futureproof their portfolios.
There may also be opportunities in UK property, for example in industrial or logistics, or residential. However, the key question is how well managers can respond to changing demand for commercial space in the years ahead.
The price of illiquidity
Property has been one of the strongest returning asset classes of the last 30 years. However, the illiquid nature of property limits the scope for managers of property funds to change direction rapidly. Some funds will fare better than others and there is a risk of a wide spread of return outcomes between different funds in coming years.
With this uncertainty, I believe there is a higher risk of redemptions for UK property funds; a trend that we had already begun to observe prior to the pandemic as pension schemes were looking to de-risk investments into bonds and undergo insurance transactions.
History has shown us that higher redemptions increase the risks of a damaging ‘redemption run’ for some property funds. In order to pay cash out to investors, managers risk being forced to sell assets cheaply, hurting fund performance and incentivising other investors to submit redemption requests too. And so the cycle continues…
In this type of scenario, I believe it is better to consider getting any redemption request in ahead of other investors or at least consider whether you should redeem part of your UK property holding and diversify into other areas.
Are there better alternatives?
In general, ‘real assets’ (ie property, infrastructure and the like) can be great investments for pension scheme portfolios. Fundamental qualities such as low correlation to other asset classes, reliable income and attractive (often inflation-linked) yields are attractive features. In my view there are a broad range of real assets that pension schemes should consider, and I wouldn’t necessarily put all my eggs in the UK property basket. I believe a more diversified portfolio of real assets would better manage risks and provide access to a broader range of opportunities.
For example, Global Property funds invest across a wider range of countries, with less exposure to the (in)stability of a single economy. , Should the London office market happen to suffer as a result of Brexit, you’re unlikely to see the same impact on offices in Japan.
In my view, Long Lease Property is less exposed to some of the structural trends threatening the core UK property market. These funds might be UK focussed, but typically have higher quality tenants (such as universities or supermarkets) and limited exposure to high street retail or shopping centres. The long-dated nature of these leases means these investments are more bond-like in nature, with returns driven by contractual rent over a long-time horizon rather than property prices. As such, these investments are also more suitable investments for a de-risked pension scheme and less exposed to the supply and demand risks that the core UK property funds face.
But property isn’t the only real asset schemes should consider. Global Infrastructure also offers attractive features. Infrastructure funds invest in companies that provide essential services to the public or other businesses. These could be your local water company, a toll road in the US or renewable energy investments in Europe. Due to a lack of competition in their markets, infrastructure companies have more say on pricing – meaning stable and sustainable income for investors.
The future of the core UK property market is uncertain. Whilst yields are still attractive compared to bonds, I believe a more diversified portfolio of real assets provides an equally attractive yield but with a significantly reduced risk.