Background

In August this year we published a review of the property sector (Hot property) as discounts widened markedly in the wake of the UK’s referendum on membership of the European Union.

Funds and investment trusts investing in the sector were hit hard by the surprise result amid fears that UK plc was about to pack up and head for Dover, leaving acres of prime office space empty, and by 6 July 2016, more than £14bn was ‘locked in’ to open ended property funds through a variety of mechanisms (gating/exit charges etc).

Against this chaotic background, reminiscent of the mass sell-off we saw in 2008, the average discount in the closed ended UK property sector – which had until that point been trading mainly on a premium – had plunged to below 16%.

We thought this panic, given how little anybody knew at the time about the implications of the result, might be an overreaction and we were not alone; Numis published an interesting piece of analysis at the same time, showing that the similarities between 2008 and 2016 were limited.

A key issue in 2008 was that many investment trusts (and funds) were owned by ‘distressed sellers’ who were in a position of being forced to sell their holdings to cover losses elsewhere. This was not the case in 2016.

A key issue in 2008 was that many investment trusts were owned by ‘distressed sellers’. This was not the case in 2016.

Numis’ research also showed that the trusts themselves were in better financial condition this time around – with far less of their underlying portfolio mortgaged than in the previous crisis; average loan-to-value ratios in 2008 were 50%, while in 2016 that figure had dropped to 30%. A secondary factor, but one of great importance, was that in 2008 the banks themselves were in trouble, so the very foundations (mind the pun) could – potentially – have collapsed had a systemic collapsed caused them to begin calling in mortgages all at once.

The final finding in the analysts’ report was that the average lease in property portfolios was over five years, giving some visibility on the yields these trusts produce – income being a core part of their attraction for many investors.

In that research we highlighted Picton Property Income, UK Commercial Property Trust and Empiric Student Property, all of which were in one way or another less exposed than their peers to the damage that a worst-case scenario, a mass exodus to Frankfurt, might cause.

However the nature of property funds’ underlying investments – which aren’t traded on an exchange – means that it is impossible to know how they have been affected by a new development like this until the portfolio has been valued, and an ‘NAV announcement’ has been published, giving an up to date valuation of the properties the trust (or fund) holds.

When we published our review, we said we were looking forward to seeing the NAV announcements these trusts, and their peers in the property sectors, released in the autumn – as only at that point would it be clear what the effect of Brexit had been on underlying valuations.

Those results have come through, now, and they are for the most part encouraging.

 

The big picture

As the chart below shows over the year to date (25 November) NAV returns – which include income generated by the underlying portfolio during the year – have been strong across the sector. The average trust in the AIC UK Property (Direct) sector is up 6% and all have delivered positive returns. Picton has led by a considerable margin, with NAV returns of 12.3%. UK Commercial Property is up 3% while Empiric – not part of the same sector, but we chose it because we thought its focus on students was interesting for those looking for a non-correlated income – is up 7.9%.

The average trust in the AIC UK Property Direct sector has returned 5.8%, outperforming the average open ended fund in the Investment Association’s property sector by a decent margin…

In share price total return terms, which include dividends paid out, performance has generally kept pace so shareholders have seen these NAV returns translate into real cash returns. The average trust in the AIC UK Property Direct sector has returned 5.8% in share price terms, outperforming the average open ended fund in the Investment Association’s property sector – up 2.2% over the same timeframe – by a decent margin.

 

Cumulative returns this year

In terms of discounts, the sector has recovered most of the ground it lost after the referendum after a hair raising drop in July and the sector has returned to an average premium of 1.6%.

 

Average discounts

The trusts

The first trust in our review, Picton Property Income released its half year results on 30 September, showing net assets had actually increased from £417m in March to £424m at the end of September. The trust saw an 8% increase in earnings from its portfolio and announced a 3% increase in its annual dividend, fully covered by those earnings. It now yields 4.3%.

Empiric Student Property published its final results for the year ended June 30 in September and again we saw a positive NAV result. The trust, which sits outside the main property sector and is a specialist, focused as the name suggests on housing for university students, recorded NAV growth of 2.1% however earnings per share dropped slightly.

While these results were not spectacular, the trust enjoys an unusual position given its unique target market, and returns are not correlated with the main commercial property markets. There are concerns over the potential for a decline in the number of foreign students coming to the UK, post-Brexit, but the trust’s board has been keen to stress that only 6% of full time students in the UK come from within the EU which may allay those fears slightly.

These trusts are interesting options offering an alternative source of income at a time when equity income funds in particular face growing pressure on their dividends…

UK Commercial Property Trust published its interim results shortly after we profiled the trust first time around showing a slight decline in its NAV which stood at 86.5p on 30 June. Since then, NAV has fallen further to 83.7p as at the end of September, however the trust has undergone considerable change under manager Will Fulton who took the reins in April 2015, and is – according to analysts at Winterflood Securities – “well positioned to take advantage of any investment opportunities that may arise as a result of Brexit”.

The analysts are referring to the fact that the trust has a significant cash pile (£114m when we spoke to the manager in July) and a £50m overdraft available, giving it one of the largest war-chests in the sector – should valuations drop and in doing so create a buying opportunity – and one of the lowest loan-to-value ratios in the meantime.

 

Conclusion

The damage done by the referendum is, as yet, limited and the generally stable results being issued across the property sector reflect this but, as we are sure you are aware and are probably tired or being told, very little has actually changed in real terms since June.

It is satisfying to see that our view in August – that the initial panic and stampede for the exits was premature and not based on sensible assessment – appears to have been proved correct. However, the sector is no longer trading on a big discount to NAV, and the damage done to share prices by that initial reaction has been erased by the sharp recovery which has taken place in the months since then.

Beware, though, the temptation to assume that capital values will not fall…

With that in mind, we present these updated trust profiles not as ‘discount opportunities’ by any stretch – that boat has sailed – but as interesting options for those who want long term exposure to commercial and specialist property, offering an alternative source of income at a time when equity income funds in particular face growing pressure on their dividends. Beware, though, the temptation to assume that capital values will not fall – particularly given the political upheaval which continues at home and abroad.