New property opportunities enable investors to target growth as well as income

0:11David Thorpe: Hello and welcome to the FT Advisor podcast. Each week we are joined by guests from the industry to discuss pressing market issues. I'm David Dorp, Senior Investment Editor at FT Advisor. Today we are discussing the role commercial property can play in client portfolios in a changing world. Joining me to discuss the topic are Marcus Fairmudge, who runs a number of property strategies at Columbia Threadneedle, Guy Foster, Chief Strategist at RBC Brewing Dolphin, and George Fox, Portfolio Manager within the Merlin Multi-Asset Team at Jupiter. Thank you all for joining me. George, if we start with you.

0:52David Thorpe: To what extent do UK and the global interest rate expectations shape how you think about a property allocation, both I suppose it's quantum and its composition? yeah so i mean it's probably just worth sort of briefly taking a step back to explain what the property exposure is that we have because it'll provide some context to some of the answers but what we've done is essentially rather than going down that more traditional route of going into a pooled vehicle we've actually set our own fund up which has two investors both of which are portfolios that we run in the jupiter merlin team and i guess the reason for doing that is because We want to avoid things like gating risks, things like cash drag that you often see within that space.

1:37And I guess more broadly have a more tailored sort of design to that fund and the exposures that we want in order for our investors to get exactly the exposure that we're looking for. I mean, back to the question, though, in terms of, I guess, interest rate expectations. You know, of course, they have they have an effect on how we think about property. I mean ultimately property like any of the assets we invest in we have to look at them on a relative basis to each other and you're very right in terms of saying it's not just a case of what type of property we want but actually whether we want property at all potentially and so in a world where you know our property portfolio was yielding about sort of four percent-ish when interest rates or where bond yields certainly in the UK were down around the zero bound that premium was really quite attractive.

2:26That was sort of back in the 2010s. Of course, we're in a bit of a different environment now. You've seen yields go up to, well, I mean, in the UK flirting with 5 % and our property exposures yielding around about 6%. So there's been a real sort of compression in that premium that you're getting on an income basis. We have reduced our exposure a bit over the last year or so as a result of potentially better opportunities elsewhere. But that being said, we still think property is a fantastic place to be. There is still a bit of a yield premium there. Of course, inflation protection is another element that a lot of people talk about, the ability to potentially grow capital over time as well.

3:07And so, yeah, we're still very excited about both that broader opportunity set, but also some of those idiosyncratic drivers that we have and that our managers, Swiss Life managers, who we've outsourced the management of that portfolio to, are also very positive on some of those things.

3:23David Thorpe: Thank you. Guy, you're the macro strategist in the room. And how do you think about interest rate expectations and how they are influencing asset prices and obviously specifically property asset prices now and the sensitivity of property as an opportunity to interest rates? Yeah, I mean, like all asset classes, property kind of has exposure to a few different factors and interest rates is certainly a big one but it's also a largely commercial asset class as well so you've kind of got some sensitivity to the economy sensitivity to growth and then you've got some sensitivity to to discount rates and if you expect that interest rates are going to be higher then you've got to recognize that That is a headwind for the asset class and a potential opportunity when you arrive at your destination.

4:20In the UK, it seems the UK stands out as having the highest rates in most of the developed world. And so it should be a bit more of a headwind here. I think rents seem to have not risen as much, or yields haven't risen as much as you would necessarily expect, given where yields are. But I think that's the expectation that hopefully, I think we all hope, that UK yields are going to kind of normalise a little bit more over the coming year. But yeah, it's definitely a component, a fairly important component, of the returns that we'd expect to get. Thank you.

5:04David Thorpe: Marcus, as the property investor around the table, how do higher interest rates impact how you put a portfolio together? Do you make money changes when rates go up or if you expect them to go up? Or if we are now at a point where maybe rates are coming down, how will that impact what your portfolios look like? Yeah, I think at the end of the day, we tend to look at, so first of all, I cover real estate equities rather than physical real estate. And our view is that, you know, investors across the globe have been to some extent ill served by these pure physical property funds because of the issue around gating, etc., which George mentioned.

5:47But putting that to one side, yes, absolutely. The equity market sees interest rates as a key driver. We see it as important but not crucial in as much as we like to talk about real estate equities as the, we're very much at the value end of the equity trade, but we're at the growth end of the bond trade. And what I mean by that is that we are providing income, but income that's growing. And so it is the underlying economic fundamentals which very much sit alongside our selection. So, you know, to Guy's point, we absolutely believe that we are reaching equilibrium in terms of where interest rates are going to settle.

6:32And therefore, for us, it's much more important to focus on where that growth is coming from. and it's a really interesting point now because rates are elevated relative to recent history yet at the same time we've got very little new construction going on because for a bunch of reasons we might discuss later and actually we're seeing very much in all sectors the prime end of the market we're seeing really quite strong rental growth and that's ultimately what's driving our behavior. But you can't get away from the fact that ultimately the cost of debt, real estate is a leveraged asset class. So that cost of money is crucial.

7:15What is really interesting is when you compare public markets with private markets, public markets, the expectation or the rule of thumb is that an LTV of more than 40 % is deemed quite extreme. Whereas in private markets, everyone's trying to gear as much as they can and sweat their equity as much as they can, whereas public markets, and that's where we see so much M &A activity and the fact that as a result, lots of opportunity in what we consider to be a very underpriced public market. Thank you.

7:48David Thorpe: And Marcus, we'll stick with you for the next question. How do you think about diversification within property as you've alluded to and as both George and Guy sort of mentioned the interest rate outlook is something that very much shapes people's thoughts on the quantum of whether they want any property at all. But can you achieve diversification in the way that you invest so that, I don't know, if things can be more or less interest rate sensitive or if it's geographical or if it's sector based? What does diversification look like in that world? It's a great question because, well, first of all, one of the great things about public markets is you can get the diversification.

8:28We run both European only funds or pan-European, like TR Property Investment Trust, the FTSE 250 only pan-European listed investment trust, as well as a number of global mandates. We also run mandates which are just Europe and US. So you can literally pick and choose your markets. Within sectors, you're absolutely right we there are highly sensitive there are sectors that are highly sensitive to to duration particularly someone like German residential where you know that the these are companies owning literally thousands of flats but the rents are highly regulated so you're only going to get CPI or just below CPI but you always have because rents are below market you always have 100 % occupancy.

9:18So the sensitivity of German residential to the 10-year Bund is, you know, it's kind of 0.8. I mean, it's very, very high. Other end of the scale or spectrum, you get sectors such as self-storage, which are highly correlated with house price growth or with number of families moving house, etc. The great thing about diversification in the listed space is there are all sorts of sectors which, as little as a decade ago, you couldn't get access to. So if you want primary health care or you want elderly care, I've mentioned self-storage, student accommodation, data centres, logistics of all types, whether you want big box or last mile urban logistics.

10:05And geographically, property is a local game. And you therefore have a – it's very easy to be able to pick. So right now, Spain is doing really, really well as a growth market within Europe. A number of Eastern European markets are really benefiting from the nearshoring, unshoring breakdown of globalization that we're seeing. A lot of Asian manufacturers coming over and finishing products for consumption in Europe, getting the sort of semi-finished article and finishing off and using much cheaper labor and real estate markets in Eastern Europe, just as an example.

10:42David Thorpe: Thank you. And George, with the approach that you have as a multi-manager, you mentioned you've created your own fund. But is diversification something that you're thinking about? And how are you trying to achieve that, given the structure that you've created and the fact that you outsource it? Yeah, so I think partly having that structure and allowing for it to be tailor-made means that, as I mentioned before, we can have it in exactly the type of exposures that we look for. And also, you know, we work very closely with Swiss Life, who, you know, we think have done a fantastic job over the years of directing us or directing the fund and the investments to the areas where that opportunity is.

11:27So first things first, it's very much sort of UK focused, rather than being a more global structure. And then, you know, this is probably a broader point that we talk about across all the asset classes we invest in is that we think it's very easy to be over diversified and actually concentration within a multi-asset fund we think is really key. If we had a 5 % exposure to this property fund I'm mentioning, even if they had a 20 % exposure within that to a single property, if you aggregate that up at the headline level, it's still only 1 % of our assets. And that's not to say that therefore we just have five properties in there all at 20%, but We want it to be concentrated enough so that the stock picking or property picking that those managers are doing really comes through and makes a real difference to the returns of our clients.

12:13That also goes to say with is the same with the types of property. So, you know, the Swiss Life managers 10 years ago when we set the fund up made a fantastic call to avoid more of the high street retail side of things, the regional offices. And instead, we're very concentrated in industrials, retail warehouses, all of which have been pretty strong growth areas within the UK commercial property space over the last decade. And so, again, we're happy for them to be concentrated in that sense, because if you take that look through sort of line of thinking, you actually don't you know, you're not actually getting as much of it as you might think you were if you were just only exposed to that fund and that fund alone.

12:53and then the final element where I think you know those managers have brought real skill is diversification of tenants because of course you know you need to think about the businesses that you're exposed to through the tenancy agreements but also when those tenancies are going to come up for expiry you don't want all of your tenancy agreements expiring one go because all of a sudden you know you might find yourself in a tricky situation so keeping that void rate nice and low, ensuring that that income's constantly coming through, working through difficult times like COVID, when a lot of cash flow is dried up for these businesses, you know, not necessarily, you know, going at them with the vinegar, maybe giving them the sugar treatment so that as a result, you can work through those difficult times.

13:34And as a result, end up, like I say, having that void rate, void rate low and keeping your tenants over the long run. So that income keeps coming into us and to our clients that I'd say those are the key elements when we think about Thank you.

13:46David Thorpe: And over the 10 year period, has the focus of what the fund invests in changed? I mean, you mentioned there wasn't a lot of high street, there's a lot of industries, but has it changed and evolved over time? I'd say actually, I mean, it's not changed a huge amount. I mean, at the margin, you know, we've sort of reduced some areas and not others. So, for example, in the answer to the last question, I spoke about reducing our exposures over the last year or so. and that's been potentially trimming some winners essentially so taking money out of areas that done very well areas that are in a strong position and therefore potentially more attractive to the market so it's easier to sell but I think actually funnily enough a lot of a lot of what the manager is still seeing as attractive is what was attractive 10 years ago that growth is still there continuing to come through I think the high street you know is continues to be a pretty difficult place.

14:35I mean, all of us, you know, being in London, you see how Oxford Street has potentially changed. And, you know, there's question marks on how that's going to develop going forward. So yeah, for the time being, I think they're sticking to their guns.

14:46David Thorpe: Thank you. And Guy, I mean, I guess from a portfolio construction point of view, one always thinks about secular growth versus cyclical opportunity. And one thinks about different return drivers. When it comes to property as an asset class, is that how we should be thinking about it in the same way that we might think about equities or or bonds or or is is it something else and what does diversification look like in the something else i actually thought the way marcus described it earlier was really good as being at the what did you say that the sort of low growth end of the equity market and high growth end of the end of the bond market it obviously does have economic sensitivity.

15:29It has interest rate sensitivity. And both of those are quite good things to have at the moment. And then it has this inflation linkage. And the way that the asset classes have evolved, because you were discussing diversification earlier, at a global level, it's become this sort of increasingly US market. The US market has become increasingly sort of data center focused. So there is definitely a risk that you can sort of drift into this just being a reflection of the same trade that is also kind of growing in all of the other parts of your portfolio. And you have to be quite careful about how you're going to implement in order to make sure this isn't just that exact same thing, but with a little bit less beta than perhaps some of the other elements.

16:22So we have an alternatives fund and we add property as a component of that. We tend to stay in property equities, take advantage of gearing that Marcus mentioned earlier. And the liquidity enables us to be relatively fleet of foot and combining it with some of the other asset classes just means that we can kind of shift from the more stable to the more sensitive elements depending upon what yields or prospective returns are being offered by those different sub-asset classes. Thank you.

17:00David Thorpe: And Guy, on that point, I mean, you mentioned data centres and actually Marcus mentioned in one of his earlier marks as well, there are types of property or types of asset classes within property which exist now at some scale that didn't many years ago. Data centres is one example of that. access to health facilities, whether that's nursing homes or primary health care centres or other things. Those things exist now that didn't in the past. I mean, from your point of view, are those interesting investment ideas? And also, what do they offer? I mean, are they even more priced off bond yields than property normally is?

17:47David Thorpe: or are they even more priced or are they potentially adding a little bit more of that growth? Because as Marcus mentioned earlier, there's low growth value and a bond. Are they a structural growth story which gives you a different type of exposure to what you might normally get with property? Yeah, we see them as being a bit more inflation linked and a bit closer, I guess, to really other forms of infrastructure. So what we have tended to do within the alternatives fund is that sometimes we're happier allocating to real estate and sometimes we're happier allocating to other parts of infrastructure or sometimes we're happier allocating away from away from both of those.

18:28But I think data centers sort of sit right on that sort of infrastructury kind of wing of the property market. And they do bring these additional features, which are, you know, which are attractive because inflation probably is the biggest concern that most of our investors, most savers in this country should really be thinking about well what is it about my portfolio that means that it's still going to be able to pay the give me the same purchasing power at some time in the future i think that is that's the challenge really that the wealth management industry is is here to solve for its clients thank you um marcus you you did allude to those areas

19:11David Thorpe: are they are they more growthy is there structural growth in something like data centers which gives Is it a different return characteristic than does more conventional property? Absolutely. It's the same with every sort of new sector, that you're in a development phase, and the question is, can you get access to the land and the power and the companies that are developing those data centres rather than necessarily owning the finished product in a more stable infrastructure style fund. And in Europe, that's exactly where we are, because there are only three companies that can give you really access to data-centered development pipeline.

20:01That's Merlin in Spain, and in the UK, it's Seagro and Tritac's Big Box. And what is so interesting is that if you've been reading the FT in the last couple of weeks, you will have noticed the approach from Prologis, which is the largest REIT, largest industrial and data center REIT in the US. Sorry, not pure data center, but it has a huge data center portfolio. And it's looking, it sees that the opportunity in the land bank. The question, of course, is you need a set of skills to do that. And one is still debating whether the management team at Seagro have that capability. So, yes, these new sectors are exciting and you want to get access to that development gain and then potentially also to own them longer term, particularly if they're let to very strong covenants of the hyperscaler rather than the co-locators.

21:01Having said that, we are always looking for businesses that are delivering, converting land into buildings and offering us that development profit as well as the long term income stream. So you really want to get a bit of both in your real estate construction. Thank you.

21:24David Thorpe: George, from your point of view, there are a list of things now that even 10 years ago didn't exist. the data centers are they interesting to you as as investment areas is there is there exposure there could could they in fact be in the infrastructure bucket rather than the property bucket that you have at murnham i mean you know we've always got to remain open-minded you know it's a very important part of of what we do and we've always got to be looking for yeah where where the next opportunities are where where the areas for growth are um i mean i think again taking that broader perspective on our portfolio construction side of things, we run daily dealing strategies.

22:02And so liquidity is a very important part of that. And so we're very conscious of how much we have in less liquid areas. And so I guess from where we are right now, I can't imagine us wanting to necessarily increase that. A very important part of what we do is making sure that our clients can take their money out whenever it is that it suits them. And so we need to provide them with that and you know potentially going into some of these areas adding more to property or whatnot could you know potentially start to hinder that or change the complexion of our liquidity profile. There is of course the opportunity for Swiss Life the asset managers that we employ to then go and invest themselves but I think the the sort of three key things that they've come up against I mean they've certainly looked at it are firstly I mean the lot sizes of these things are tend to be absolutely huge and so there's that sort of capital element to it secondly you know they're highly specialized sort of kit on which is put of course on top of the land so there's a question of whether the opportunity is in the land or more in the kit and the operators you know then the next question is well are you better off playing it through an equity play through those operators which of course has been you know a great place to be over the last six months, maybe barring the last couple of weeks or so.

23:20And then the third point being the fact that, you know, with any emergent asset class, us and Swiss Life take a healthy dose of sort of scepticism about, you know, these potential opportunities. Of course, the growth projections look incredible. They always will do when the narrative is strong. But I think, yeah, we've just got to sort of maybe watch a bit more from the sidelines. And, you know, if Swiss Life did manage to find a smaller lot that they could potentially get access to you then have other issues like maybe it's run by a smaller operator is that smaller operator less well established potentially a high risk sort of tenant type thing to to have um you know i think all of a sudden the valuation that you thought you had on that property and and with all that specialized kit can evaporate in an instant if that operator is no longer around to to run it which i think is is a broader point is worth making here in terms of that element of valuation reality versus maybe what the valuers are talking about.

24:19We've seen in a lot of these less liquid areas where you have these independent valuers putting prices on things, particularly in the private equity space, but I'm sure it also happens within property. And when you actually come to sell it, all of a sudden, the valuation isn't quite what you might have expected. As we all know, investments are only worth what the next person is willing to pay for it. And you can see quite a big difference, sometimes a big gap between that valuation and where the asset actually ends up being sold. From our perspective, we're really glad that the last three properties we sold were all broadly sold at or around the valuation that they put them in there for.

24:55And so as a result of that, hopefully Merlin clients can rest assured that the valuation we have of their units is a pretty accurate one. And hopefully they're not going to be getting any nasty surprises like you do sometimes elsewhere.

25:07David Thorpe: Thank you. Guy, with the various client portfolios that RBC, Blue and Dolphin run, obviously some of those clients will have income as a priority or as a consideration. To your mind, does a property allocation get a bigger role for an income client than a non-income client? Is that sort of standard practice? If you have, say, a trust structure that requires a clear distinction between income and capital growth, then I think real estate is going to be pretty helpful from that perspective because it's going to give a little bit on both sides. So that's useful. In general, we think that investors will find it easier to meet their objectives if they think in terms of the total return.

26:00And you can just see there's a deviation from property. But obviously, in terms of a lot of operating companies, particularly those in the US, the excess profit they make, they plough back in the form of share buybacks. So great for total return, terrible if you're relying upon dividends. Some of the high dividend yielding companies that you find are yielding a lot because there's risk to those dividends. So I think it has become probably more the case than in decades gone by that investors should think in terms of the total return. But property has a role to play from that perspective as well, because it gives you a little bit of capital growth and a bit of income.

26:44When we talk about data centers, you get a little bit less upfront income, but you get that a bit more growth and inflation linking. Thank you.

26:55David Thorpe: Marcus, in your strategies, how do you think about that balance between income yield and capital appreciation? And do the bulk of your clients ask you first about the dividend outlook? Yeah, so we run a number of strategies. I've already mentioned TR, Property Investment Trust. The TR obviously originally stood for Touche Remnant, which was a fund management house back in the day. When we moved to Thames River Capital, we told them we only moved there because of the name. But now we say TR stands for total return. So that vehicle very much is a total return. We also have a fund called Property Growth and Income, which very much delivers that quarterly income.

27:34So that's a crucial component. But at the heart of it, and therefore you can choose whether you lean towards total return or to income, as Guy mentioned. But at the heart of it, the REIT structure, the Real Estate Investment Trust, whichever structure, whether you're talking about the US or the UK or slightly different structures across Europe or even as far afield as Japan and Singapore, at the heart of it, your structure is tax-free as long as it distributes somewhere in the region of 85%, 80 % or 85 % of its income. So by very definition, these are income focused vehicles. And under the heart of it, even if you're a developer focused business such as Derwent London or Great Portland, Helical Bar, you're creating an asset which then has income.

28:27And you're then selling that asset to somebody who wants that income stream. So it all comes back at the end of the day to income. But you're dead right. It is about market timing and cycles. And, you know, there are moments where you want to own those assets, those companies which are most sensitive to bond yields because you think those yields are coming down. And other moments in time where, you know, there's an inflation surge or you're catching a very undersupplied market and there are significant capital growth opportunities. So it's horses for courses through the cycle. Thank you.

29:04David Thorpe: George, obviously at Merlin you have strategies for clients with different priorities. You've mentioned how you give those clients access to property as an asset class. Do your income clients have more of that strategy than might a gross client or a cautious client? And where does it fit on the risk tolerance scale as well? Yeah, so I mean the two portfolios that have access to it are sort of broadly in the middle. so you're bang on in terms of it's it's yeah more the income focus not that growth end and and less of that cautious end as well you know in terms of how important income is to property investments hugely I mean it's if you disaggregate the returns of the the Swiss life funds that we have 80 % of it's come from the income stream and it's a very key part of how we think about it it's certainly a very key part of of how they think about it when thinking about where the opportunities are um thinking about sort of striking their agreements on on tenancies and whatnot um having that element of income and as as marcus was saying earlier you know having that growth in there as as well in in that income is is hugely important so yeah it's it's certainly a big part and um definitely more income focused clients have more access to it thank you well much food for thought for advisors there and thank you for listening and thank you to marcus who runs a number of property strategies at columbia thread needle thank you to guy foster chief strategist at rbc brew in dolphin and thank you to george fox portfolio manager within the merlin multi-asset team at jupiter thank you all for listening and do remember to tune in to future editions of the ft advisor podcast thank you

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