In line with the wider UK real estate market, portfolio performance was impacted in the reporting period by external events. A rapid increase in interest rates, firstly in the U.S., as governments sought to grapple with rising inflation and the impact of Russia’s invasion of Ukraine. This was further exacerbated in the UK by the policies of Liz Truss’s Conservative government, which caused a sharp spike in the UK gilt rate.
Debt costs increased significantly as a result and many previously acquisitive investors temporarily withdrew from the market. These combined factors led to a general rerating of property yields with the lowest yielding properties, which were predominantly industrial assets, experiencing rapid and significant yield expansion. CBRE’s prime industrial yields moved out 150 bps from June 2022 until end of December 2022. As a result, the Company’s strategic overweight position to the industrial sector was the primary driver of portfolio underperformance over the year against its MSCI benchmark, with a total return of -13.3% versus -9.6% for the benchmark. Positively, over all longer term periods and since its inception, the portfolio continues to outperform its MSCI benchmark. The table above sets out the components of these returns for the year to 31 December 2022 with all valuations undertaken by the Company’s external valuer, CBRE Limited.
Environmental, Social and Governance (ESG)
Whilst real estate investment provides valuable economic benefits and returns for investors, it has – by its nature – the potential to affect environmental and social outcomes, both positively and negatively. The Company adopts the Investment Manager’s expansive policy and approach to integrating ESG in all areas of its investment process, and this has been used as the basis for establishing the Company’s ESG objectives.
Both the Investment Manager and Board view ESG as a fundamental part of their business. Given the significance, and at times quite technical content of ESG and its application, we have dedicated a separate section of our report to the topic which follows. 2030 – Achieve Net Zero Carbon across all portfolio emissions under the control of the Company as landlord. 2040 – Achieve Net Zero Carbon across all portfolio emissions – both those controlled by the Company as landlord and all the emissions of its tenants and embodied carbon from development activity.
Full details of our Net Zero Carbon Strategy can be found on page 22. Energy Performance Certificates (EPCs) Energy Performance Certificates (EPCs), which each property legally requires, form a powerful regulatory measure by which government can encourage the UK property industry to decarbonise. Draft legislation applying to England and Wales indicates that all property must have an EPC of class A, B, or C by 2027 and A or B by 2030. The legislation and rating scale in Scotland are different and there are currently no similar minimum standards based on the EPC system. 76% of the Company’s portfolio by ERV in England (it does not own in Wales) is currently rated A, B, or C. This is a positive position; however every property is kept under review and where asset level interventions are required we aim to do so at commercially sensible times such as lease expiries or during renewal discussions.
There are also instances within the portfolio where there is no need to make improvements as the asset will be entirely redeveloped to modern and fully compliant specification at lease expiry. Our embedded approach to ESG is carried through to our approach to development where we target an EPC of A as well as strong BREEAM ratings. With the forthcoming development completions, we expect the percentage of the portfolio with an EPC rating of A-C to increase.
Despite the unprecedented adjustment to values, particularly in Q4 of 2022, as a result of macroeconomic challenges, your Company’s portfolio is firing on all cylinders on an operational basis, reporting strong earnings growth through 2022 and demonstrating with early-2023 leasing activity the real potential for continued rental growth. With debates in full flow as to the depth of the 2023 UK recessionary environment and likely inflation levels, as well as how the Bank of England will adjust interest rate policy, your portfolio is well placed with its emphasis on industrial stock, particularly in London, to benefit from one of the most under-supplied sectors in the country where demand remains positive.
The Company has the potential to benefit from both earnings growth and, in the future, capital values. Earnings growth would be generated through continuing to unlock the portfolio’s “reversion conversion potential”, whereby the higher rental values of asset are converted at lease events to cash rents received, as well as through development projects coming on stream.
Following rises in interest rates, capital values have declined which presents an opportunity for valuations to increase as income grows and an expected interest rate cutting cycle commences which expands the margin between property yields and the risk free rate, increasing the attractiveness of the sector to investors. Of course, it would be naïve to assume there will be no tenant bumps along the way, however, the portfolio is relatively protected from the riskiest areas such as F&B, leisure, fashion retail and the uncertainty around reletting older, non-ESG compliant office stock.
Conversely, some tenant failure on our industrial estates would offer the opportunity to enhance rental income by earlier reversion capture. As such, we are comfortable with the current structure of the portfolio although will remain alert to the potential to prune assets where we see undue risk or limited potential. Proceeds from any such pruning would most likely, in the short term, be deployed to reduce the modest level of drawn “floating interest rate” debt before redeploying when we have more confidence on the expected future timing of interest rate cuts. In essence, our strategy is very straightforward – maintain our robust balance sheet and focus on continuing the progress we have made to improve earnings through leasing activity and successful completion of our modest development pipeline, while remaining alert to market opportunities linked to an eye on future interest rates.