For many reasons, including those I highlighted last week, the investment companies UK commercial property sector is out of favour. Abrdn Property Income (API ) released a positive update last week without much impact on its depressed share price so is worth a closer look.

The attention-grabbing numbers on API are a very wide and cheap discount of 39% and a yield of 8%. One problem API has is it is relatively small with a market value of £193m. Another is its 2.2% ongoing charges ratio. The recent underlying investment performance with net asset value (NAV) down 16.3% over the past 12 months is off-putting too and merits some investigation.

The investment trust has some debt, which has amplified the NAV fall, but this does not look excessive with a loan to value (LTV) ratio of 28.1% as at 30 June, although it rose quite a lot from 22.6% at the end of last year.

The £467m portfolio is biased heavily towards industrial property, which accounted for 54% of the company at half-year stage. This had been a big contributor to API’s returns in 2021/22, but as interest rates have climbed, yields on even this popular part of the property market have advanced too, pushing down valuations.

About a fifth of the portfolio is exposed to offices, where the trend towards working from home that was amplified by the pandemic has dented confidence. Around 16% is in retail, but most of that is in retail warehouses. The balance is in other commercial property and land. The allocation to land includes one of Scotland’s largest reforestation and peatland restoration projects.

The vacancy rate at the end of June was 8.2%. That has been gradually falling, which is important as empty buildings put a serious dent in the NAV. Just shy of 96% of the rent due was collected over the first half of 2023.

For some time now, the dividend has not been covered by earnings, which puts a question mark on the yield into some people’s minds. Dividend cover for the 2022 financial was 97%, but for the first half of this year it fell to 81%.

The recent news is encouraging in this regard. Over £1m per annum of new deals have been completed in the office portfolio. Some of this is helping to bring down the vacancy rate, while other deals are delivering decent rental uplifts. In the industrial portfolio a new 20-year lease was signed for an uplift of 19.4% on the previous passing rent, and interest in a speculative 107,000 sq ft industrial scheme under construction, that should complete at the end of the year, is said to be good. Altogether, this activity should have brought the vacancy rate down to about 4.4%.

Traditionally, property has been perceived as a good asset to own in periods of inflationary, as over time rents tend to move with inflation. However, valuations had to adjust to reflect the higher interest rate environment. The worst of that happened in the second half of 2022, as is reflected in the 12-month NAV return. The question is, have interest rates peaked and valuations bottomed?

The Bank of England has kept rates at 5.25% for three months now. While it is keen to keep up the pressure on inflation, and rate cuts are off the table for some time yet, there is a possibility that we are at the peak of rates. That would be great news for the property sector, and immediately after the rate decision on 2 November, API’s shares, along with a raft of real estate investment trusts (Reits), jumped, closing nearly 7% higher. However, now we wait to see how severe the UK’s economic slowdown gets as the effects of higher rates work their way through the system.

RICS published its third quarter commercial property monitor last month. For API, there was good news in that industrial demand is still good and rental growth is expected. The outlook for prime offices is thought to be positive too. However, secondary offices and retail are expected to experience more challenging conditions.

Nevertheless, API’s fate is not just determined by market moves and the manager’s asset management initiatives can make a big difference to returns. Lead fund manager Jason Baggaley observes that occupiers are putting more emphasis on buildings’ green credentials, especially in areas such as energy efficiency.

This has been an area of focus for the fund for some time and deputy manager Mark Blyth sounded an upbeat note in the update, saying: ‘Reducing void property costs and increasing rental income, whilst at the same time ensuring a strong focus on ESG, will strengthen API’s overall financial standing and position it well for the future.’

A total of 84% of API’s portfolio now has an EPC rating above C, up from 56% in June 2022, and the manager is still driving improvements in this area.

API’s debt is structured as an £85m term loan that matures in 2026 and, after some rejigging last year which lowered API’s dividend cover, pays interest at Sonia (the Libor replacement) plus 1.5% with a cap of 5.46%. This loan is fully utilised, but it also has an £80m revolving credit facility which has the same rate of interest but without the benefit of the cap. At 30 June, £50m was drawn on the facility and, with the inter-bank lending rate at about 5.2%, this costs the fund 6.7%. The half-year report in September suggested the managers might look at paying down the facility through asset sales.

I think that what this all boils down to is a Reit that is doing a reasonable job in the circumstances. It seems likely that the dividend cover situation will improve. I cannot say with certainty that the NAV will rise from here, but the discount looks way overdone.

James Carthew is head of research at QuotedData.

Any opinions expressed by Citywire, its staff or columnists do not constitute a personal recommendation to you to buy, sell, underwrite or subscribe for any particular investment and should not be relied upon when making (or refraining from making) any investment decisions. In particular, the information and opinions provided by Citywire do not take into account people’s personal circumstances.