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Paying the rent

9 November 2018

Ian Cowie examines the advantages of investment companies in the property sector.

Income-seeking investors should consider above average yields - that is, dividends expressed as a percentage of share price - available from the rents paid in commercial property sectors. For example, while most types of investment trust yield an average of about 3.3%, investors can obtain nearly two thirds more income from the Association of Investment Companies (AIC) Property Direct UK sector, where the average yield is 5.2%.

Pooled funds - such as investment trusts or unit trusts - enable individual investors of all sizes to participate in commercial property, despite the fact that individual office blocks, factories, shopping malls and warehouses may each cost millions of pounds. Pooled funds, as their name suggests, bring together many investors’ money to share the cost of acquiring commercial property and the expense of improving and maintaining these assets, which would otherwise be beyond the pockets of all but the richest individuals.

However, higher rewards in the form of above-average yields may be accompanied by higher risks - and some of these are less obvious than others. One danger is disruptive technology or the growing popularity of shopping online which has rendered some retailers less competitive and hit the capital values of associated forms of property, such as some shops.

British Home Stores and Woolworths were among the best-known brands on the high street before these ‘bricks and mortar’ shops were forced out of business by new competition, including ‘clicks and mortar’ internet retailers, such as Amazon and Google. Even household names including Debenhams, House of Fraser and Marks & Spencer have been forced to close some stores recently.

Professional fund managers seek to minimise risks and maximise returns from commercial property by selecting assets which can deliver rental income and preserve capital values. For example, Calum Bruce, investment manager of Ediston Property Investment Company, said: “The retail market is facing a number of challenges but it is important to distinguish between high street, shopping centres and retail warehouses.

“The first two sub-sectors will be hardest hit and the current high vacancy rate will trend even higher. Our company has no exposure to these two sub-sectors. However, the retail warehouse vacancy rate is at its lowest level ever at about 4.5%.”

Strong demand for warehouses needed to distribute goods bought online underpins the capital value of these properties and the rental income they generate, which contributes to Ediston’s 5.5% dividend yield. Foreign & Colonial Commercial Property, is another fund in this sector - with widely-diversified total assets of more than £1.3bn - and a yield of 4.4%. Both these funds distribute dividends monthly, which can be useful for investors whose priority is income.

More focussed exposure to specific aspects of real estate can be obtained through funds in the AIC Property Specialist sector. As their names suggest, Empiric Student Property and GCP Student Living set out to serve the need for accommodation at universities and generate dividend yields of 5.3% and 4% respectively.

Similarly, Impact Healthcare Real Estate Investment Trust (REIT) and Primary Health Properties provide some of the buildings required by the National Health Service and generate yields of 5.8% and 4.9% respectively.

Another option in this sector is Triple Point Social Housing REIT which provides accommodation for people with special needs, often funded by housing associations, and currently yields 3.6%.

Investors seeking specific geographical exposure to commercial property can also consider AIC sectors such as Property Direct - Asia Pacific and Property Direct - Europe.

In all the above cases, investment trusts’ closed-end structure gives them and their shareholders an important advantage over investors in other forms of pooled funds, such as unit trusts or open-ended investment companies (OEICs). Commercial properties tend to be ‘big ticket’ assets where the price of a single factory, office block, or warehouse will often run into several million pounds.

That is why these properties are sometimes described as “illiquid assets”. It can be difficult to turn them into cash or even to put a realistic value on what they might fetch, particularly during periods of rising anxiety and falling prices.

During such periods of market uncertainty and volatility, open-ended pooled funds such as unit trusts and OEICs have been forced to suspend trading, preventing individual investors from getting back into cash, until calmer conditions prevailed. Even in more normal circumstances, open-ended commercial property funds often hold more than a fifth of their assets in cash in order to maintain sufficient liquidity to meet redemptions by unitholders.

By contrast, closed-end commercial property funds have no need to maintain substantial cash holdings to meet redemptions by investors because the price at which their shares trade on the stock market will reflect variations in demand, without any need to sell underlying assets. These investment trusts’ share prices may rise and fall and their discounts to net asset value (NAV) may narrow and widen but their fund managers should not be forced to sell in order to raise cash.

That may sound like a technical difference between closed-end and open-ended pooled funds but it gives the former a substantial advantage over the latter, which is particularly important when managing inherently illiquid assets, such as commercial property. These factors also explain why commercial property investment trusts tend to offer higher yields than their open-ended rivals and, with very few exceptions, have delivered higher total returns over the last year, five and 10-year periods.

No wonder the City regulators are consulting on how open-ended commercial property funds can protect the interests of unit holders and address structural problems with liquidity - or their ability to let investors get back into cash.

You might not think that liquidity would be a problem in a sector such as commercial property where rental yields supply a stream of income. But the value or price of any asset is ultimately determined by what someone is prepared to pay for it. Or, as city cynics sometimes say, revenues are vanity, profits are sanity but cash is reality.

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