Standard Life Investments

Insight

Standard Life Investments' Will Fulton thinks income will play an important role for property investors in 2018 as capital growth continues to wane...

When investing in UK commercial property, income is a vital component of overall returns. In fact, research shows that over the long term, it is income, not capital growth, which has been the biggest contributor to total returns for commercial property1. Income comes from a tenant paying rent, and a contractual lease is in place to help ensure that the income stream is regular and reliable.

Total returns were better than expected for investors during 2017, but this is unlikely to be the case in 2018. Capital growth is likely to be more subdued, so an ability to create and drive income will be vital for property investors. And while interest rates and bond yields are still low by historical standards, the income generated by property continues to look attractive to other investors too.

Will Fulton, manager of the UK Commercial Property Trust (UKCPT), sees considerable potential to increase income within the investment trust. Following a significant restructuring of the portfolio from 2015 onwards, he believes the Trust is well positioned to increase earnings growth.

A preference for the industrial sector is a key part of this strategy, where the growth of online retail is continuing to have a positive effect as demand for warehouses and distribution centres increases. Around 36% of the Trust is held in the industrial sector and around 70% of those assets are in the South East2, which in our view offer greater rental growth potential. For example, supply is particularly restricted here given pressure for other land uses, such as residential. This is also the most expensive area for industrial assets given land prices and high levels of demand. In addition, the Trust currently has a vacancy rate of 7.6%3 – approximately three quarters of which is in the industrial sector – so there is an opportunity to raise rents with new leases.

A good example of our success in this sector is Ventura Park, a 35-acre industrial estate located off the M25 at Radlett. Following an extensive £1.2 million refurbishment, we are seeing strong occupational demand and we are targeting a rent of £8.50 per square foot. This should provide £1.3million of rent a year – a 42% increase from when we purchased the asset in 2015.4

The other area of the market that we think is selectively well placed to provide income is the prime, “bulky goods” retail warehouse sector. Well-located, out-of-town retail parks close to major and economically strong conurbations offer a convenient shopping experience. They usually offer ample parking, click & collect, and often leisure facilities such as restaurants to encourage shoppers to spend more time in the park. Within the Trust, we currently prefer assets in this sector and hold a larger weighting than our benchmark index, particularly compared with shopping centres where we hold a low weighting having recently sold three shopping centres in Shrewsbury to Shropshire Council.

In terms of other sectors, the Trust has a lower weighting than the benchmark in central London offices (2.2%5 exposure in the City of London) given concerns over pricing, the impact of shorter leases on income, and worries over the effect Brexit will have on property demand and potential rent decreases in the capital. Poorer-quality retail is also vulnerable – again, the Trust maintains a lower-than-benchmark position. The problems in the retail sector are well documented and we expect further polarisation between the best and the worst areas in the future. Weaker retail sales and structural changes in the retail sector are forcing retailers to review the number of shops they occupy on expensive high streets.

As well as a well-positioned portfolio, the Trust currently also has the advantage of an attractive dividend yield of 4.1%6, a strong balance sheet, low gearing, and financial resources available for investing. And with its shares currently trading at a 3%7 discount to net asset value (NAV), this may represent a good opportunity for some investors to obtain more shares for their money.

1 Source: Standard Life Investments MSCI annual index 1980 to 2016, Quarterly Universe 2017, Feb 2017
2 Source: Standard Life Investments, 31 Dec 2017
3 Source: Standard Life Investments, 31 Dec 2017
4, 5, 7 Source: Standard Life Investments Mar 2018
6 Source: Standard Life Investments – In comparison to other asset classes, such as government bonds and cash.” (UK 10-year Gilt yield was 1.5% as at 19/3/2018).