M&G Treasury & Investment Office (T&IO) Commercial Property Update

4 minutes read
Last updated on 21st Aug 2020

T&IO has put together a useful reminder of our position in terms of UK commercial property prompted by the increased interest in the asset class from our clients, and looks to address some of the main questions we’ve seen in recent weeks:

  • PruFund portfolios have bespoke allocations to UK real estate that insulates its investors from some of the issues that affect collective funds (i.e. gating, suspensions, cash drag). But it doesn’t insulate investors from all issues that challenge real estate markets during times of stress. Naturally underlying portfolios are exposed to the broader challenges facing certain sectors/sub-sectors and tenants and ‘independent valuation uncertainties’ have been applied.
  • Property has generated strong risk adjusted returns for portfolios over many years and Prudential/T&IO/M&G remain committed to the asset class, whilst acknowledging the very challenging environment.
  • We believe the spread between government bonds and property yields still makes the asset class attractive. With monetary stimulus packages expected to keep interest rates and bond yields at low levels for the foreseeable future, this is likely to remain the case for some time.
  • The overall allocation to UK property in PruFunds has reduced slightly in recent years as the team has sought to build exposure in the major international real estate regions (North America, Europe and Asia).

We can't predict the future. Past performance isn't a guide to future performance.

So what has happened in the property market year to date?

  • Q1 saw capital values fall 2.6% according to the MSCI broad property index.
  • Retail has been the hardest hit – discretionary retail, leisure and hospitality in particular – with office and industrial sectors only marginally down.
    • The high street was already facing significant challenges with the growth of online shopping, but many real estate teams were already looking at how the sector may evolve – turnover-based rents, building more residential etc.
    • M&G Real Estate has sold several smaller high street units over recent years.
  • In contrast, ‘essential’ retail businesses continued trading, so food operators and pharmacies, have performed well. Amongst them, the major winners are the traditional grocers, the ‘big four’, benefitting against discounters from more mature distribution capabilities.
    • Retail parks and grocery-led assets, anchored by large supermarkets, are also faring better and we have some exposure to these assets.
  • The logistics sector has fared better overall, owing to the reacceleration in e-commerce use during lockdown.
    • This possibly heralds a permanent shift in shopping habits, which in turn is likely to boost logistics space demand.

We have been asked a lot about offices in particular and whilst it is still too early to come to firm conclusions as this sector adjusts to the new ‘normal’:

  • For many organisations, the transition from the office to working from home has largely been seamless, triggering conversations on the future of the workplace. 
  • Some sectors in the office space will face significant challenges however a lack of supply had restrained vacancy rates and some ongoing development will be delayed or stopped in the short-term.
    • This could support a rental growth rebound for the best-quality stock, once economic activity returns
    • For example occupancy within the City of London and surrounding areas occupancy was at 10 year + highs in the lead up to the pandemic
  • We expect well-specified and well-located Grade A offices, particularly within central business districts, to remain at the heart of companies’ workplace strategies, driven by the need for more and enhanced collaboration spaces.
  • The gap between secondary and high-quality Grade A space is expected to increase, as occupiers place a growing importance on health and wellbeing. PruFund portfolios own more high quality Grade A offices.
  • Shared office operators remain under pressure, reflecting lower occupancy rates in the face of the shift to working from home and on-going social distancing rules.
    • We believe the trend towards the need for increased flexibility and short-term solutions for occupiers will resume, ensuring co-working spaces remain a vital part of the office scene over the long-term.
  • Some businesses are likely to adopt a wait-and see approach, before signing new leases or looking to expand into new space.
    • This puts pressure on short-term rental forecasts but the delay to planned future developments will further restrict supply and keep vacancy rates low for best quality stock.

Summary

  • Investment activity is expected to remain muted in the near-term.
    • Indications are that valuations are down a further 5% over Q2 across the broader market.
    • A lack of market liquidity combined with weak occupier sentiment will most likely place upward pressure on property yields.
    • That said, banks are better capitalised than before the Global Financial Crisis and regulators are also encouraging a more lenient approach to loan covenant breaches, helping to mitigate the need for forced selling.
    • There are signs that activity is starting to pick up after a very quiet second quarter.
    • At present, well located, modern assets with resilient income are holding their values. If challenges persist in the aftermath of COVID-19, we could see a growing opportunity to acquire assets at a discount.

The value of commercial property, like other asset types does carry risks and it’s value can go down as well as up, so your clients’ may not get back the amount they invested. The situation with Commercial Property, like other asset types, is still fluid given the pandemic and the market is still evolving.

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