The lack of market confidence in the outlook for commercial real estate can be seen in the almost daily announcements of wind-ups or mergers associated with UK commercial property investment trusts and the sales of marquee buildings at prices which reflect a poor return on investment for investors.
But with interest rates falling, and technology companies and others mandating staff to spend more time in offices, could the asset class be due for a revival?
At the other end of the trade, portfolio risk monitoring outfit Dynamic Planner removed property as an asset class from its portfolio metrics.
Matthew Norris, senior portfolio manager at Gravis Capital, says we have reached that point, but with one part of the market unlikely to ever recover.
He says that with corporate bond and gilt yields falling materially as UK base rate falls, the relative attractiveness of the income available from commercial property rents rises.
Norris says data from Knight Frank shows that valuations for most commercial property assets have “stabilised” recently, which he says is noteworthy at a time when the economy generally has struggled.
But he adds that with rates likely to fall from here, he expects the stabilisation of prices to convert into rising prices soon.
The extent of the decline and the gradual nature of the recovery is outlined by Aaron Hussein, market strategist at JPMorgan Asset Management.
The growing demand for sustainable properties, combined with the shift to remote work, poses a significant challenge for older office buildings.
He says: “The sharp rise in interest rates has hit the commercial real estate sector hard, with property values in the US, Europe, and the UK dropping by 15 per cent to 25 per cent – the biggest write downs since the global financial crisis. Commercial property values appear to have bottomed out in late 2023.
“As we move through 2024, we’re seeing clear signs of stabilisation and modest gains. For properties with strong fundamentals, today’s valuations potentially offer investors a once-in-a-decade opportunity.
“Historically, investing at or near the start of a rate-cutting cycle has delivered above-average long-term returns.”
Norris’ optimism is, however, centred around properties that have modern energy efficiency ratings and prime locations, with the rest becoming what he calls “stranded assets”.
UK government regulations mean that from 2030, property with an energy efficiency rating of below B will not be permitted to be let out, meaning owners will have to spend considerable capital improving the buildings.
Most recently constructed or renovated property will meet energy efficiency criteria, but older buildings and buildings in regional locations are less likely to, says Norris, who anticipates many of those buildings will not be sellable.
There is already evidence of a ‘brown discount’ in action.
The downward trend associated with regional office assets can be seen in the most recent set of results of the Regional REIT, which wrote down the value of its assets by 5 per cent in the six months to the end of June 2024, and announced that around £20mn of the capital it raised from a recent share issue would be deployed on renovating and redeveloping assets within its portfolio.
Its a point taken up by Peter Hewitt, who runs the Columbia Threadneedle Global Managed Portfolio trust, a vehicle that invests in other investment trusts.
He says he has reduced his property exposure, and presently only owns assets such as Land Securities, which owns large landmark buildings in London, as well as a trust that owns care homes, and so should benefit from changing demographics rather than suffer as a result of those, which is the case for companies that own assets that might perform less well as a result of changing societal patterns, such as the tendency to work remotely.
Culture clashes
Norris says that at present only around 16 per cent of commercial property assets in the UK have the right energy efficiency rating now.
He notes an opportunity may present itself for a development company such as Derwent, which he feels has the resources and inclination to buy up such properties cheaply and redevelop them to the right energy efficiency standard.
When it comes to the potential for regional or thematic differences to persist for the long-term, Hussein says a “bifurcated” market is being created based on location, with empty offices tending to be clustered together, while offices that are lettable are also centred in prime locations.
He says: “There is already evidence of a ‘brown discount’ in action. In the US and Europe energy efficient assets are showing stronger investment performance compared to their inefficient counterparts, particularly in the office sector.
“The growing demand for sustainable properties, combined with the shift to remote work, poses a significant challenge for older office buildings. These properties risk becoming stranded assets if their owners don’t take action to bring their buildings up to a higher standard.”
The direction of travel for property markets remains opaque due to the lack of visibility on both the economy and monetary policy.
Peter Dalgliesh, chief investment officer at Parmenion, says he continues to favour property within balanced portfolios as a way to add diversification within portfolios, but adds that the demise of open-ended property funds means one can only access the asset class via real estate investment trusts, products he is wary of as he feels they require an investor to take equity market risk, rather than be a diversifier away from equity market risk.
Ben Yearsley, investment director at Fairview Consulting, has been buying UK property trusts recently. He says: “We have probably had the blow out in the sector, with capital values falling, but we have probably seen the bottom of that now. So as an investor maybe you have missed the bottom, but with a 5 per cent yield, that’s fine as it’s more than the 4 per cent yield on government bonds right now.”
Darius McDermott, adviser to the VT Chelsea range of multi-manager funds, holds Reits in all four of the products on which he advises. He says the opportunity from his point of view was that the investment trusts in question began to trade at very wide discounts to their net assets, so he began to buy.
His view is that as bond yields have fallen, so the relative attractiveness of the income from property trusts increases, and people will begin to buy those, pushing the prices up and closing the discounts.
James Sullivan, head of partnerships at Tyndall, says: “We do not currently source explicit property exposure in our models, choosing to have some look through access to the likes of British Land and Land Securities through much broader, more diversified UK plays.
“Property via an open-end structure has no place within a retail friendly portfolio due to the liquidity mismatch. However, property via a close-ended vehicle such as an investment company or a Reit would form part of any regular sector appraisal, albeit, remains arguably a thin end of the wedge.
“Many property trusts trade on very material discounts to their net asset values as the market sentiment remains somewhat negative. This may be an opportunity for some to collect ‘prime’ property on handsome yields, but the opportunity cost of waiting for a re-rating whilst the rest of the market runs hard can be quite hard to stomach.
“The direction of travel for property markets remains opaque due to the lack of visibility on both the economy and monetary policy in the short term, paired with the work from home phenomenon that is now commonplace.”
David Thorpe is senior investment editor at FT Adviser