The UK's commercial property sector is facing a significant sell-off, investors and asset managers are grappling with the complex task of valuing their portfolios in this shifting landscape. With rising interest rates and evolving market conditions, traditional methods are proving insufficient.
Property fund investments are relatively straightforward. Investors gain access to diversified property portfolios through professionally managed funds. These properties generate rental income, with a portion distributed to investors as dividends. When these properties appreciate or are sold at a profit, investors witness the appreciation of their holdings.
Commercial property vehicles can take two primary forms. Some function as investment funds, facilitating the flow of capital in and out from investors. Fund managers must ensure adequate liquidity is available to meet redemption requests and in times of heightened demand, fund suspensions may occur until sufficient assets (properties) are sold to meet the withdrawal requests. The second structure comprises stock market-listed investment companies or trusts, offering investors the ability to buy and sell shares. Nonetheless, share prices may not fully reflect the value of the trust's property assets, leading to shares trading at a discount.
From interpretation of the ‘RICS Economy and Property Market Update August 2023’, the commercial property sector faces a challenging landscape marked by economic uncertainty, a rapid increase in debt costs, persistent high inflation, and uncertain corporate demand. These difficulties are compounded by structural shifts in demand, which have been accelerated by the pandemic.
Some of the key takeaways from this report is that the property market sentiment has shifted in Q2, with 68% of respondents perceiving a downturn, up from 50% in Q1 but below the Q4 2022 peak of 83%. Expectations for the next 12 months indicate robust rental growth for prime industrial properties (+42%, down from +58% in Q1) and prime offices (+22%). Secondary offices are at -47%, indicating a quality-based divergence.
Recent financial turmoil has led to liquidity issues in the commercial property market and even some significant property funds suspending dealings due to surges in redemption requests. With interest rates continuing to rise and markets forecasting another potential hike, we may see capital values of commercial properties fall further and diminish the appeal of property funds compared to safer income alternatives like gilts. The near term forecast for capital values of property funds is weak and looking at backward markets data and trends, a reversal in gilt yields is needed before a reversal in capital value can be seen in property, although there is likely a bumpy ride yet to be seen.
Analysts perceive these discounts as opportunities for long-term investors, provided these prices recover, and a positive sentiment returns to the asset class. In summary, while UK commercial property has faced challenges, opportunities may lie ahead for investors willing to navigate this evolving landscape with prudence and adaptability.