Three positive plays on property

Each week,  a professional investor tells MoneyWeek where she’d put her money now. This week: Delyth Richards, Head of Funds Research, Kleinwort Benson.

UK commercial property continues to deliver for investors. So far this year the sector has returned 15%, outperforming every other mainstream asset class, according to data from the Investment Property Databank (IPD). In all, for 2014 as a whole, the sector looks set to generate the highest returns it’s seen since the financial crisis.

The economic backdrop in the UK remains supportive for investment in commercial property too, and there’s plenty of evidence to suggest the market remains in good shape. We’ve also seen retail investors invest a lot of money over the past 12 months.

However, when a sector has charged ahead as much as this one has, it’s worth exercising some caution. So this is a good time to start asking – when will it make sense to get out of the sector?

We have some concerns about the growing enthusiasm for the sector. As well as continued strong demand from overseas and institutional investors for UK real estate, we’ve seen the aforementioned hefty retail investor flows into property funds.

Many property funds have substantially higher levels of assets and hold large amounts of cash, making it difficult for managers to invest in sufficient property assets at attractive valuations.

History shows that retail investment flows are vulnerable to changes in sentiment. If investors all want to get out at the same time, this creates challenges for managers. Property is not an asset that can be bought and sold overnight.

On top of this these same retail investors are often exposed to changes in interest rates, as is property as an asset class – leverage (ie, using borrowed money) is a core component in the commercial property investment market.

But despite these challenges, there are specific factors that remain supportive of the sector. Commercial property rental values are now growing at their fastest rate since December 2008, with rental growth of around 2.5% over the past nine months.

The growth is well spread too – each of the core sub-property asset classes saw gains, although growth of retail rents remains muted, according to the IPD. Returns – based on an initial yield of 5.5% – remain attractive compared to other asset classes.

Investors should pay particular attention to the supply and demand dynamics of the UK market. Rental growth is of course a factor. The UK commercial property market does not currently have the high levels of oversupply seen in previous market cycles.

In the central London office market, for example, the most recent Deloitte Crane Survey reports that 41% of new office space in construction has been let. And despite a rise in new construction schemes over the past six months, 2015 is expected to deliver the lowest volumes of new space seen in the past 20 years.

Total space under construction in central London is at its lowest for three years, below the long-run average. This remains supportive for rental growth, and rents are set to continue to rise.

So, despite some worrying signals, we remain positive on the sector, but will keep a close eye on any significant movements. We expect a slowing of capital growth in the sector and may look to rotate some holdings into listed Real estate investment trusts (Reits), where asset management and development opportunities offer ongoing drivers for growth.

As such, we continue to recommend three property investments: British Land (LSE: BLND), Schroder Real Estate Investment Trust (LSE: SREI), and the Henderson UK Property fund.