Opportunity knocks on buildings that look

Just months after commercial property fund valuations fell rapidly – preventing some private investors from withdrawing their money – managers are launching more products, citing new opportunities in global real estate.

Back in December, this might have unlikely. Falling yields, defaulting tenants and lock-ins on open-ended funds were some of the reasons why investors were avoiding the sector.

But already, conditions may be improving. In recent weeks, fund managers have been talking about “finding opportunities” in undervalued properties.

BNY Mellon Asset Management has just launched a real estate investment trust (Reit), the Mellon Global Property Securities Fund, through its subsidiary, Urdang Capital Management.

Todd Briddell, chief investment officer, says valuations are now at “a compelling level”. He believes property fundamentals remain strong and says that the negative sentiment in the UK relates to declines in price only, arguing: “The long-term nature of most leases should be able to insulate fundamentals.”

Investing globally in property is also an advantage, Briddell says, because of the different opportunities in each country. “There is no such thing as a global real estate market,” he says.

The fact that closed funds can trade at a discount may offer particular advantages given that property valuations are still falling.

Michael Morris, fund manager of ING’s UK Real Estate Income Trust, says: “While we expect capital values in the underlying market to still see some further declines in 2008, as the fund is priced reflecting a 30 per cent discount to NAV, downside risk is already priced in.”

Open-ended managers reply that while investment trusts can trade at a discount, their funds can benefit from buying property at a discount.

Howard Meaney, head of property investment at LV= Asset Management, says the company’s open-ended fund, the LV= UK Property Fund launched last September, has not done as well as hoped, raising just £27m. But he says that it has nonetheless taken advantage of the weaknesses that have come through, buying defensive stock at discounts.

While he thinks values will fall by another 5 per cent this year – they have fallen 5 per cent already since January, according to IPD data – he believes that drop is already reflected in property, explaining: “Valuations tend to lag the market so we can buy properties at the moment that anticipate that drop, almost like derivatives.”

In general though, those being bullish about commercial property’s prospects are in the closed-ended arena. It is the open-ended commercial property funds that have hit the headlines for imposing redemptions on investors. Fund managers will not turn down new business, but those stung by poor press reports when they put locks on investors taking their money out last year are still not advertising the funds.

Many, such as New Star UK Property and the Norwich Property Trust, are still on a bid price, suggesting the funds are still in net outflow. The case for going back into an open-ended fund is not strong.

Ana Cukic-Munro, co-head of Insight Investment’s Multi-Asset Group, goes as far as to say: “Only a foolish or naïve investor would consider investing in an open- ended property fund right now.”

However, M&G recently moved its Property Portfolio to an offer price. Fund manager Fiona Rowley says: “With the market looking increasingly attractive to long-term investors, we would expect yields to stabilize later this year.” But M&G is cautious about reading too much into its move to offer price, saying that if the trend was to change in the future, the price could swing back to cancellation.

Meanwhile, Morgan Stanley will next week launch a structured product specialising in commercial property, which offers investors the opportunity of benefiting from growth if they think commercial property will have risen in value six years from now.

But more important than the type of vehicle is the strength of commercial property as an asset class.

Morris says that with all the focus on declining property values, investors tend to forget that income remains steady even in times of market downturn, as shown in the graphs below. The first graph shows rental income growth and rental value growth. Morris says: “The graph shows that even when rental values decline, underlying income from commercial property portfolios has actually risen.”

The second graph shows that even during the property slump of the mid-1990s, rents remained stable.

“The reason income has increased is that in any portfolio you have, contractual leases benefit from upwards only rent reviews,” Morris explains. He says this is a great advantage of UK commercial property – Europe, for example, tends to have index-linked reviews.

However, it is possible, particularly in today’s climate, that tenants can default, others warn. Meaney points out that if a tenant defaults on a high rent and the property has to be put back on the market, this would cause a significant reduction in rent. What is more important, he says, is the quality of the client – it is important to look for stable renters for properties.

The Royal Institution of Chartered Surveyors said last month that demand for commercial property in the UK in the first quarter of
this year fell at its fastest pace in more than six years. But even the lack of demand for commercial property
is not necessarily a bad thing, fund managers say.

Briddell says: “From a supply perspective, we’re not witnessing a supply recession. There might be weakness in terms of demand but that should be able to be carried over due to long-term leases.”

Another point is that commercial property investors rely on debt markets to fund purchases. On the one hand, the credit crunch has affected their funding. But on the other, falling interest rates are likely to spur growth as property investors rely heavily on debt.

Alan Patterson, head of European research and strategy at Axa REIM, says: “The nature of property income flows is quite stable in the medium term so banks are willing to lend quite a lot against it.” With interest rates going down, he says property investors will maximise their gearing, giving them more money to invest in property which stimulates the market.

Others see opportunities in stagflation, which some believe could hit again as the economy slows but inflation rises. Patterson says construction is particularly hit by inflation with the rise in commodity prices such as steel, making it likely that existing supply will continue to be constrained in the short term as it is simply too expensive to build.

For investors on a medium- term horizon, this could be a benefit, he says. “If you take a five-year time horizon, there will be a lagged benefit in that as demand comes back from tenants, there will be limited supply as there will have been no new development. Even when demand picks up, the cost of buildings will still be high.”

Generally, there is agreement that the bottom of the commercial property market has not yet been hit, but fund managers stress that the long-term investor should not focus on this too much.

Briddell says it is “very difficult to call” the bottom, but says: “We want people to see this not necessarily as a tactical short-term investment that’s only going to go up. From a big picture view, the valuations today are very compelling.

“Is next month going to be a better entry point than today? I don’t know. But I can guarantee it’s better than a year ago and fantastic over the long term.”