The idea of investing in UK property might make you fearful given political instability created by the upcoming general election and ongoing Brexit saga. But there is genuine merit in having exposure to UK property as part of a diversified portfolio given its enduring income appeal.

We believe this exposure should be selective. In this article we identify four of our prime property picks, each of which play into different market hotspots.

INVEST FOR INCOME

There is the option of investing directly in property, either for development or to let, however recent regulatory changes have made this more complicated and you also run into risks such as a lack of diversification and liquidity.

As well as helping you to achieve diversification, a fund or listed property firm opens up access to a wide variety of different types of property including shops, offices, warehouses, homes and alternative assets like healthcare facilities and student accommodation.

As valuations recovered following the financial crisis, investors had the luxury of enjoying both capital growth and income from property. These two sources of return are measured by declines or growth in net asset value (NAV), i.e. changes in what a property investor’s holdings are worth minus any liabilities, plus the yield achieved by renting out properties.

Capital growth through increases in NAV might be more difficult in the current environment, given a more volatile backdrop and depressed level of transactions but savvy property pickers should still be able to generate sustainable and inflation-busting income.

Stephen Inglis, chief executive of London & Scottish Property Investment Management, the asset manager of Regional REIT (RGL) which invests in offices and warehouses outside London, says: ‘We have extensive experience in dealing with similar assets through the 2008-2012 downturn where the valuations fell but income was maintained. In fact, the income was increased by 3% over that period.’

‘PLENTY TO LIKE ABOUT UK REAL ESTATE’

Peter Lowe, manager of BMO Real Estate Investments (BREI), comments: ‘There is plenty to like about UK real estate, not least the yield premium, income growth in most sectors outside of retail, good levels of occupancy for quality stock and a relative absence of typical “late cycle” behaviour in the lending and development space.’

Yield premium refers to the higher levels of income on offer from real estate relative to other assets like bonds.

RETAIL PROBLEMS

As Lowe’s comments suggest, while all parts of the real estate market are exposed to fluctuations in the economy, retail as a category faces a particular challenge.

This is caused by structural changes not related to the usual ebb and flow of the market, namely the fact that many of us are choosing to shop online rather than on the high street or in shopping centres.

It is putting pressure on rental income from shops and occupancy rates and feeding into valuations.

The struggles in the retail sector are neatly illustrated by recent results from two of the largest investors in UK property - real estate investment trusts British Land (BLND) and Land Securities (LAND).

On 12 November Land Securities announced overall like-for-like net rental income up 1.4%. For offices income was up 2.5%, specialist properties enjoyed growth of 7.7%, but income from retail tenants fell by 1.5%. Asset values were down 2.8% largely linked to the company’s shopping centre and retail park holdings.

On 13 November British Land revealed the value of its shopping centres, retail parks and shops had fallen by £599m in six months, or 10.7%, to £4.8bn.

OFFICES

Office properties operate on a two-speed market in the UK. In London there has been plenty of building activity, even in the wake of the Brexit vote, with cranes dominating the skyline. Outside London this is generally not the case and there has been very little new building in the last decade or more.

This creates stronger dynamics for the regional office market, where the limited new supply of office space helps support returns from existing properties. As the chart shows, returns from this part of the market have been higher than in London in recent years.

Nick Montgomery, head of UK real estate investment at Schroders and who steers Schroder Real Estate Investment Trust (SREI), highlights the example of Cheltenham which benefits from playing host to UK spy agency GCHQ.

‘This was one of the best performing parts of the portfolio in our recent half year period.’

US defence firm Northrop Grumman is the trust’s main tenant in the Gloucestershire region and, as Montgomery observes, there is no new supply in that area which is driving rental growth.

That does not mean the London office market should be written off. A recent third quarter update from Derwent London (DLN), which as its name suggests is focused on the capital, showed a 46% jump in lettings and a fall in its vacancy rate to 0.6%. Of its three major developments, representing 790,000 square feet of property, 70% is pre-let. Derwent doesn’t just invest in offices, but they account for the bulk of the portfolio.

Its latest figures are testament not just to the quality of this portfolio but also to the enduring appeal of London despite Brexit-related uncertainty. Many businesses are still going to look to base themselves within the M25 to be close to the centres of finance and politics in the UK.

The greater focus of international capital in London offices means valuations are arguably more sensitive to Brexit outcomes than those of regional offices. Montgomery at Schroders says there is a ‘wall of capital’ sitting on the sidelines which could be released in the event of greater clarity on the political situation in the UK.

OFFICES TOP PICK:

Buy Real Estate Investors at 53.4p

Discount to forecast NAV: 25%. Forecast yield: 7.1%

Improvements to transport connections and population migration from London are helping to support office property valuations in the Midlands and Real Estate Investors (RLE) offers a way to play this positive trend.

Liberum says: ‘Improving regional conditions provide the backdrop for further growth in rents, which should enhance Real Estate Investor’s already high income return.’

Offices represent 38% of the portfolio. Based on Liberum’s forecasts the company trades at around 75% of net asset value and offers a well-covered yield in excess of 7%.

SHOPS

The structural shift in the retail sector, where the internet has gone from accounting for less than 3% of total retail sales in 2006 to nearly 20% today, has proved toxic to retail property valuations.

Tenants who historically rented large numbers of physical outlets have struggled and in some cases gone out of business while more savvy operators have been reducing their physical footprint and driving a hard bargain on rental discussions.

The two main specialist investors in this space, Hammerson (HMSO) and Intu Properties (INTU), trade at substantial discounts to net asset value principally because people still do not see a floor for valuations in the sector.

Fund manager Alex Wright believes this has created an opportunity in Hammerson. Wright, who steers the Fidelity Special Values (FSV) investment trust, says: ‘The UK-focused retail landlord faces challenging fundamentals but its current discount to NAV more than compensates for this situation. This low starting point offers limited downside and we expect management to pursue further asset sales and bring down leverage.’

In our view it is too early to call a recovery in retail, particularly if one of your principal aims when investing in property is to secure a stable stream of income.

Notably Intu, which has a more strained balance sheet than Hammerson, was forced to cancel its dividend in February 2019 thanks to its big borrowings, falling rental income and the dwindling valuation of its assets.

WAREHOUSES

Retail woes haven’t extended to the warehouse sector where demand is rising for storage and distribution centres to facilitate online orders.

The requirement to serve customer demands for click and collect and delivery to the doorstep, as well as the expectation for online retailers to offer an efficient returns system, creates a need for different types of warehousing space and plenty of it.

These assets are typically leased on long-term rental agreements which are linked to inflation and the markets have switched on to the appeal of such industrial assets. Landlords of warehouses command premium valuations and one player, Segro (SGRO), has even ascended to the ranks of the FTSE 100.

There are broadly three types of warehouse asset. Big box or mega distribution facilities which are upwards of 500,000 square feet; regional distribution units which are between 100,000 to 500,000 square feet; and last mile or urban logistics which tend to be 100,000 square feet and below.

Heightened competition for assets has put pressure on the yields available when acquiring operational assets, particularly larger super-sized or big box warehouses. The larger size of these assets makes them attractive to a range of institutional investors.

It now looks like the market is settling down. Warehouse REIT (WRH) raised cash in April for a £133m spending spree on multi-let warehouses in the 100,000 square feet and below category which is its sweet spot.

Andrew Bird, managing director of Tilstone Partners, which manages Warehouse REIT, says: ‘When we raised capital it was all about the fact open-ended funds had started selling and some of the heat that we had in the market 12 months ago was just coming off. Reality had come into the market as investment volumes came down.’

Bird points out that Warehouse REIT is still able to acquire assets at less than the cost of construction. This suggests that while the economies of scale might make it worth developing a big box asset from scratch, smaller warehouses just aren’t commercial to build. This should see supply remain constrained and support rental income from this part of the market.

WAREHOUSES TOP PICK:

Buy Warehouse REIT at 106.7p

Discount to forecast NAV: 3%. Forecast yield: 6.3%

Its portfolio is focused on smaller to medium-sized warehouses in urban locations with good transport links. For the most part this is catering for tenants involved in ‘last mile’ delivery - serving the last line in the supply chain from the online retailer to the customer’s doorstep.

Constraints on the supply of this type of facility mean the company should be able to boost rental income, particularly as it refurbishes recently acquired assets and this in turn should underpin dividend growth. Unlike some of its larger peers, which trade at big premiums to the value of their assets, it trades at a 3% discount to forecast NAV.

HOMES

The argument against having exposure to residential property in your portfolio is a straightforward one. Anyone who owns their own home already has a lot of money tied up in this area of the market, even if it is not being held as an investment.

In addition, growth in house prices has begun to stall. However, the pressures on housing supply and the affordability issue means there is still a lot of demand for rental properties in the UK.

Among them is Residential Secure Income (RESI). Fund manager Ben Fry says: ‘Our target returns are just rental returns - we’re not looking for any house price growth, we’re purely a rental product.’

He argues the niches in which the company is active provide a ‘great opportunity’ to achieve a secure return which grows with inflation over time.

HOMES TOP PICK:

Buy Residential Secure Income at 90p

Discount to forecast NAV: 16.7%. Forecast yield: 5.6%

Residential Secure Income invests in three main areas which all encompass what Fry describes as ‘economically insensitive tenants’. This includes retirees paying rent out of their pension, people in shared ownership schemes and local authorities trying to meet statutory requirements for housing in their areas.

‘All political parties are in favour of shared ownership, the independent retirement living sector has huge demographics behind it, and the homeless situation is huge and not going anywhere,’ adds Fry.

Residential Secure Income operates in a broadly similar space to several other trusts but has unfairly been dragged down by a storm around supported living where it has no involvement.

Supported living describes the arrangement whereby someone who has or wants their own home also has support from a care provider to help them live as independently as possible.

The supported living space has been hit by interventions from the regulator of social housing. It has issued negative notices against several of the big housing associations used by Civitas Social Housing (CSH) and raised questions over the model which sees associations, despite being low on capital, entering lengthy property leases with the likes of Civitas and Triple Point Social Housing (SOHO).

The association with the problems facing some of its peer group sees the shares trade at a significant discount to NAV. Numis says: ‘Given that Residential Secure Income does not have exposure to supported living, we feel the current discount is unjustified.’

ALTERNATIVES

Some types of property don’t fit neatly into any of the traditional categories and these have typically been labelled as ‘alternative property’.

They include health facilities, hotels, leisure centres and student accommodation.

A report from global real estate services firm Cushman Wakefield shows alternatives are increasingly moving into the mainstream, growing from 5% of UK commercial real estate investment volumes in 2009 to 28% in 2018.

Some niche areas benefit from particular drivers which make them less exposed to what is happening in the wider property market and the economy.

ALTERNATIVES TOP PICK:

Buy Assura at 71.6p

Premium to forecast NAV: 27.6%. Forecast yield: 4%

FTSE 250 constituent Assura (AGR) designs, builds, invests in and manages GP surgeries and primary care centres in the UK.

The NHS appears to be a priority across all political parties in the UK and there is a need to update and upgrade its existing buildings. The organisation says up to 3,000 centres are not fit for purpose which, as Assura CEO Jonathan Murphy tells Shares, ‘creates a positive backdrop for us’.

As broker Stifel notes: ‘Assura operates 560 medical centres out of a total addressable UK market of 9,000, offering plenty of opportunity for substantial expansion in the medium term.’

The shares are not cheap after a strong run in 2019 and trade at a sizeable premium to net asset value but still offer an attractive yield given the security of the income stream and the scope for growth.