Is UK commercial property ripe for an upturn?

This article was originally published in The Telegraph.  

It has been a long and painful journey for investors in two of Britain’s biggest commercial property companies. In October 2015 you would have had to pay 870p for a British Land share. Today you can pick one up for around 340p. Buying a Land Securities share eight years ago would have set you back just over £14. Today, it’s yours for £6. 

This week’s results from these two high-profile real estate investors showed why their share prices have tanked in recent years. But they also hinted at why the UK commercial property sector may be bouncing along the bottom and ripe for an upturn.  

On the face of it, both companies’ half year earnings announcements were poor. British Land reported a further 2.5% decline in the value of its nearly £9bn portfolio of London offices, warehouses, and retail parks. Land Securities’ £10bn portfolio, which includes the Lakeside and Bluewater shopping centres, was worth 3.6% less in September than six months earlier. 

They are not alone in seeing the value of the buildings they own fall in recent years. A combination of rising interest rates and changing working patterns since the pandemic has caused a significant downward revaluation of property prices, particularly those of offices. 

The share prices of quoted property companies are doubly vulnerable to a weak property market. Obviously, the value of their assets declines as prices fall, but at the same time investors also demand compensation for the likelihood that prices will fall further by pushing the shares to a discount to their reported net asset value. Both British Land and Land Securities have share prices that are significantly lower than the book value of the buildings they own. 

The discount is how the stock market protects itself from the inherent illiquidity of commercial property. You can’t sell a bit of a big building and if you are a forced seller of the whole thing, you might have to accept less than you think it is worth. This is one of the reasons why investing in commercial property through an open-ended fund - one that is obliged to meet redemptions on a daily basis if necessary - is a bad idea. 

But assuming you have dealt with the liquidity issue by investing via a closed-ended fund such as a REIT (real estate investment trust), the market’s scepticism about the outlook, expressed through the discount, can be your friend. With discounts of 40% or more today, this feels like one of the rare moments in investment when Mr Market is handing out something for nothing. 

It is always darkest just before the dawn and markets move not when the sun rises but when the first glimmers of light appear on the horizon. Both of this week’s results announcements offered a glimpse of brighter times ahead. 

British Land said it expects rents to grow at the top end of its previously forecast range as it pointed to a vacancy rate of 4%, around half the sector average. And it is not just talking the talk. When Facebook-owner Meta recently walked away from an unwanted tenancy agreement and offered a replacement tenant, British Land turned it down. It preferred to take the eight-storey building near Regent’s Park back onto its books because it believes it can strike a better deal today than it did when it signed the contract with Meta two years ago. 

Land Securities, meanwhile, said this week that it expects to be putting the money it raised last year from property sales back into the market next year at more favourable prices. Its confidence is underpinned by the fact that occupancy rates are a lot better than they look on the surface. The company said that 40% of vacant space is in just 1% of buildings. Ignore these possibly obsolete properties and the rest of the market is tighter than it seems. 

So, what is the case for investing in commercial property today? First, the interest rate cycle, which has been such a headwind for the real estate sector, is turning as inflation finally slows. Falling interest rates will make the reliable income streams from the best properties seem increasingly attractive. 

Second, the income available from real estate, unlike that earned from fixed income investments like bonds, tends to grow over time. This is particularly so in a modestly inflationary environment because a tenant that is able to raise its own prices is relaxed about paying higher rent itself. 

Third, the income yields on commercial property are already high thanks to the correction in property prices. So too are the actual yields enjoyed by investors after the fall in share prices that we have seen in recent years. Both British Land and Land Securities have yields of around 7%. Please note this is not guaranteed. 

Fourth, property can help investors to diversify the risks in their portfolio. This is particularly important given the increasing tendency of bonds to behave similarly to shares. Investors who could create a smooth ride with a simple 60/40 split of equities and bonds now need to look further afield to create a balanced portfolio. 

Fifth, for property investors with the right skills, today’s market offers plenty of opportunities to add value over and above the return of the broader market. This is particularly the case in the under-supplied market for buildings that are compliant with new environmental regulations. Some market watchers are talking about a ‘green building super cycle’. 

Finally, back to those discounts. Property portfolios may not be worth as much as their most recent valuation. But that has already been priced in by some of the discounts available today. One well-established investment trust, the Balanced Commercial Property Trust, has reported assets of 117p per share and a share price of just 63p. You only have to pay 64p for £1 of assets with Land Securities. At British Land it is just 55p.  

Five-year performance table 

Past performance is not a reliable indicator of future returns 

Source: FE, from 15.11.18 to 15.11.23 Basis: Bid to bid with income reinvested in GBP. Excludes initial charge. 

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Funds in the property sector invest in property and land. These can be difficult to sell so you may not be able to cash in this investment when you want to. There may be a delay in acting on your instructions to sell your investment. The value of property is generally a matter of a valuer's opinion rather than fact. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.