- Commercial property is one of the few asset classes to have delivered positive returns for the year to date
- However, headwinds are building in the form of higher inflation, rising interest rates and weakening economic growth
- Targeting structural growth sectors, careful asset selection and a focus on ESG will be vital in this environment
Commercial property has been relatively resilient amid a turbulent start to 2022. It remains one of the few sectors to have delivered positive returns for the year to date, at a time when equities and bonds have sold off concurrently. However, it is not immune to an increasingly challenging economic environment and there will be implications for investors in the sector.
There are a number of headwinds building in the second half of 2022. Inflation has proved stubborn, leaving central banks little choice but to pursue aggressive interest rate rises. The energy crisis is curtailing the ability of consumers and corporates to spend. Economic growth is weakening with no immediate prospect of a resolution. Against this unforgiving backdrop, commercial property fund managers need to focus on areas of structural growth, where tenant demand is secure and cash flows are inflation-protected.
For the property fund managers at abrdn, portfolio construction is viewed through a lens of environmental and social criteria. Across all property sectors, it is becoming a factor in tenant decision-making and there are real risks to property that doesn’t meet certain standards. It has become a swing factor in the office market as well, where companies are often trying to work out their post-pandemic working arrangements.
Mark Blyth, deputy fund manager on the abrdn Property Income Trust, says: “Every decision we make has environmental, social and governance (ESG) factors at its heart. This includes appraising potential investment opportunities or with our existing holdings, where we are constantly assessing the potential to improve a property’s appeal to occupiers. Our conviction is that strong ESG credentials will be a driver of future performance.”
“Within the office market, for example, sentiment among occupiers has quickly shifted to become far more focused on space that ticks the boxes on ESG. Employers recognise that, post-pandemic, they need to offer their staff an attractive place to work to encourage them back into the office. So to cater for this, seeking not only improve the environmental footprint of the property as much as possible, but also install the right occupier amenities. In doing so, we aim to ensure that the property is ‘future fit’. This is starting to drive divergence in performance between offices.”
Sector selection
It is also vitally important to be hunting in the right areas. Our view is that all property assets could see some repricing over the next year, with higher borrowing costs impacting valuations. However, there will be a real difference between sectors. For example, while there have been opportunities in selected retail assets, the sector is subject to some powerful structural changes, such as ecommerce and needs to be approached with caution. In contrast, the industrial sector has, over recent years, proved a far more fertile hunting ground for investors, even if performance has weakened in the short-term.
Mark says: “Although there has been a recent price correction in logistics assets we remain supportive of the sector as tenant demand remains robust. Wage costs and the rising cost of materials is limiting opportunities for development, with very low levels of supply leading to rental growth. We have two units that have seen a change in tenants during 2022. Both have already been let to new parties – significantly ahead of the previous rental levels.”
The logistics sector in Europe also has strong fundamentals. Evert Castelein, manager of abrdn European Logistics Income plc, says: “We need 300 million square feet to meet demand for logistics across Europe, equivalent to 4000 football fields. There is demand from near-shoring – companies moving back to Europe, holding higher inventory or supply chain diversification – and ecommerce. This is driving significant demand and leading to an undersupply situation.”
Tenant selectivity
However, even within these high growth areas, selectivity is needed. Within logistics, for example, Evert is focusing on those parts of the market that are most liquid and that have a second life if tenants leave. He adds: “That way, we’re not nervous if a tenant is leaving because they can be replaced.” This has seen him focus on medium-sized units, rather than the very largest options, which are harder to fill.
A close focus on tenants will also be important. The pandemic tested resilience for many commercial property tenants and this new environment will also present real challenges for certain segments. There is a wide divergence between retail opportunities, for example. Mark says: “Food will be robust, but there are challenges in high street and shopping centres. Where we have retail holdings, we are focusing on food and discount-led retail.”
There are significant benefits to finding the right options within commercial property. With secure tenants, it is possible to create a resilient, inflation-adjusted income stream alongside long-term capital growth. This is valuable in an environment of weaker growth. The cash flows from commercial property are often directly linked to the Consumer Prices Index, so their income grows in line with inflation. This should help defend commercial property against rising interest rates and a higher cost of debt.
Maintaining diversification is also important in this environment. It is febrile economic situation and it is important to sustain a spread of sectors and opportunities. Mark says: “We currently have 49 holdings in the portfolio, drawing the best opportunities from a spread of sectors.”
This is unquestionably a difficult economic climate and commercial property cannot escape these pressures entirely, but many commercial property opportunities don’t need rapid growth to thrive. There are structural factors that will drive income and capital growth over the longer-term. Commercial property should offer resilience at a tough moment for investors.
Important information
Risk factors you should consider prior to investing:
- The value of investments and the income from them can go down as well as up and you may get back less than the amount invested.
- Past performance is not a guide to future results.
- Investment companies can borrow money in order to enhance investment returns. This is known as ‘gearing’ or ‘leverage’.
- However, the use of gearing can result in share prices being more volatile and subject to sudden or large falls in value. Where permitted an investment company may invest in other investment companies that utilise gearing which will exaggerate market movements, both up and down.
- There is no guarantee that the market price of the Company’s shares will fully reflect its underlying Net Asset Value.
- As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
- Investing globally can bring additional returns and diversify risk. However, currency exchange rate fluctuations may have a positive or negative impact on the value of your investment.
- The Company may hold a limited number of investments. If one of these investments declines in value this can have a greater impact on the fund’s value than if it held a larger number of investments.
- Property values are a matter of the valuers’ opinions and can go up and down. There is no guarantee that property values, or rental income from them, will increase so you may not get back the full amount invested.
- Property investments are relatively illiquid compared to bonds and equities and can take a significant length of time to sell and buy.
- The Company invests in a specialist sector and it will not perform in line with funds that have a broader investment policy.
- Derivatives may be used, subject to restrictions set out for the Company, for efficient portfolio management in order to manage risk. The market in derivatives can be volatile and there is a higher than average risk of loss.
- The value of property and property-related assets is inherently subjective due to the individual nature of each property. As a result, valuations are subject to substantial uncertainty. There is no assurance that the valuations of Properties will correspond exactly with the actual sale price even where such sales occur shortly after the relevant valuation date.
- Prospective investors should be aware that, whilst the use of borrowings should enhance the net asset value of the Ordinary Shares where the value of the Company’s underlying assets is rising, it will have the opposite effect where the underlying asset value is falling. In addition, in the event that the rental income of the falls for whatever reason, including tenant defaults, the use of borrowings will increase the impact of such fall on the net revenue of the Company and, accordingly, will have an adverse effect on the Company’s ability to pay dividends to Shareholders.
- The performance of the Company would be adversely affected by a downturn in the property market in terms of market value or a weakening of rental yields. In the event of default by a tenant, or during any other void period, the Company will suffer a rental shortfall and incur additional expenses until the property is re-let. These expenses could include legal and surveying costs in re-letting, maintenance costs, insurance costs, rates and marketing costs.
- Returns from an investment in property depend largely upon the amount of rental income generated from the property and the expenses incurred in the development or redevelopment and management of the property, as well as upon changes in its market value.
- Any change to the laws and regulations relating to the UK commercial property market may have an adverse effect on the market value of the Property Portfolio and/or the rental income of the Property Portfolio.
- Where there are lease expiries within the Property Portfolio, there is a risk that a significant proportion of leases may be re-let at rental values lower than those prevailing under the current leases, or that void periods may be experienced on a significant proportion of the Property Portfolio.
- The Company may undertake development (including redevelopment) of property or invest in property that requires refurbishment prior to renting the property. The risks of development or refurbishment include, but are not limited to, delays in timely completion of the project, cost overruns, poor quality workmanship, and inability to rent or inability to rent at a rental level sufficient to generate profits.
- The Company may face significant competition from UK or other foreign property companies or funds. Competition in the property market may lead to prices for existing properties or land for development being driven up through competing bids by potential purchasers.
- Accordingly, the existence of such competition may have a material adverse impact on the Company’s ability to acquire properties or development land at satisfactory prices.
- As the owner of UK commercial property, the Company is subject to environmental regulations that can impose liability for cleaning up contaminated land, watercourses or groundwater on the person causing or knowingly permitting the contamination. If the Company owns or acquires contaminated land, it could also be liable to third parties for harm caused to them or their property as a result of the contamination. If the Company is found to be in violation of environmental regulations, it could face reputational damage, regulatory compliance penalties, reduced letting income and reduced asset valuation, which could have a material adverse effect on the Company’s business, financial condition, results of operations, future prospects and/or the price of the Shares.
Other important information:
Issued by Aberdeen Asset Managers Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Registered Office: 10 Queen’s Terrace, Aberdeen AB10 1XL. Registered in Scotland No. 108419.
Find out more at eurologisticsincome.co.uk and abrndpit.co.uk. You can also register for updates or follow us on social media: Twitter and LinkedIn.