In the space of just a few weeks we have seen huge political and macroeconomic changes in the UK. I am now more convinced than ever that interest rates will not move much above 2%-2.5% for several decades. In fact, I suspect rates will probably fall from here, and that we'll see more quantitative easing and even "helicopter money" within a few years as the Bank of England tries to shield us from a post-Brexit downturn.
However, despite ongoing low rates, I also suspect we'll look back on 2016 and see that UK commercial property was in the late stages of its post-2008 recovery cycle, especially in highly valued areas such as London and the South East. That doesn't necessarily mean prices will dive. But I suspect there will be more rental growth than capital growth at this stage.
So what does this mean for individual income-orientated funds? Many income niches have held up incredibly well: infrastructure funds, medical property businesses, and asset-leasing funds all had a cracking few weeks post-Brexit. This isn't a huge surprise in a world where interest rates stay lower for longer, investors will be forced to hunt down alternative income opportunities, and asset-backed ones will top the list.
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However, some niches have been hit hard. Direct (peer-to-peer, or P2P) lending funds have lost an average of 4.5% in value over the last four weeks. This isn't really about Brexit instead, shock revelations at leading US loans platform LendingClub have hit confidence in the sector hard. My gut feeling is that these fears are overdone, and that if discounts in these investment trusts hit 20%-25%, we'll see a rebound.
Student loan funds, on the other hand, have thoroughly deserved the hit they've taken in recent weeks. I reckon the higher-education business model massive growth, funded by rising student debts and plenty of foreigners paying high fees is dead in the water. That's because Brexit will lead to a crackdown on intakes of foreign students. It's a lunatic policy, but it's likely to happen, and investors look as though they might have woken up to that fact.
But the biggest post-Brexit moves have been in commercial property. A gaggle of leading open-ended property funds have experienced very public suspensions (see below). I have no sympathy for these investors why on earth put money into an illiquid asset class through a liquid fund?
Talk to any experienced property funds investor and they'd suggest using closed-end vehicles (investment trusts) where price discovery is almost instant. But the turmoil in the open-ended sector will continue to have knock-on effects outside these funds. Several listed UK property investment companies have seen their share prices fall sharply.
According to broker Numis, the average discount to net asset value (NAV the value of the underlying property portfolio) in the sector is currently 14%, while some of the larger funds are now on discounts of more than 20%.
These funds won't need to sell any assets at fire-sale prices, says Numis they aren't carrying a lot of debt, and they don't have the same redemption pressure as open-ended funds do. But "it is hard to know exactly where discounts will bottom, and in the short-term it is difficult to swim against the tide of open-ended outflows which are likely to put continued pressure on capital values".
In short, investors are trying to work out whether the property cycle is about to take a big downswing is this a "2008 moment"? Fund managers at wealth firm Heartwood think not, and I agree. Property funds now hold a lot more cash than in 2007, which should ease the selling pressure. Average debt levels are also "far lower than 2007". For example, big developer Land Securities' loan-to-value ratio was 60% (in other words, it had debts that came to 60% of the value of its assets not unlike a mortgage) in 2007, but is now just 19%.
Finally, "UK banks are also better capitalised, which will reduce fears of contagion into the broader market" (see below). Investors I've talked to also report that there's no panic as yet. "Tenants are still taking new leasing and signing without any renegotiations," one source told me although he also expected to see "more suspensions and repricing of these [open ended] funds".
The worst-case scenario is that we see both falling capital values and weak rental growth in the City. But on the upside, many key markets now look very cheap for new buyers from abroad. I also think that both London and the UK will look very attractive as a "real" asset class over the next five years.
We might see a nasty reassessment in the short term, of course, but this necessary re-rating has clearly already begun in closed-end property funds which are starting to look attractive. In some cases we're seeing discounts of more than 20% and yields in the 5.5%-6% range some value is starting to emerge. Top of my watch list right now? I'm keeping a close eye on Picton Property (LSE: PCTN), which is on a discount of 7.5% and yields 4.9%, and Schroder Real Estate (LSE: SREI), which yields more than 4.5% and boasts a discount of nearly 20%.
The big freeze on property funds and how to avoid one in future
Eight fund-management companies, including Standard Life, Henderson and M&G, have now frozen withdrawals from their commercial property funds, in an effort to stem mass redemptions post-Brexit, writes Sarah Moore. A total of £24bn sector-wide is held in these open-ended funds, of which £15bn has been frozen. Aberdeen Asset Management and Legal & General, meanwhile, have imposed penalties on redemptions investors can still sell, but will receive back significantly less than before the devaluation. (Aberdeen even temporarily suspended trading to enable investors who had decided to sell before the announcement to change their minds.)
There is some concern about a knock-on effect: several multi-asset funds also own these frozen property funds. For example, Prudential runs a £129m multi-asset product with a 15% stake in M&G's suspended commercial property fund. Yet it seems unlikely that these sorts of levels of exposure would be sufficient to force suspension of trading. And while, inevitably, there have been many comparisons with 2008 the last time commercial property funds were "gated" most believe that things aren't as bad today (see above).
Meanwhile, UK banks are also less exposed to the commercial property sector than in 2007/2008 (see below), say analysts at research group Bernstein, meaning the potential for a domino effect is lower.
If you have invested in one of the funds, the only realistic thing to do now is to sit tight. Commercial property is an illiquid asset the idea that you will always be able to get access to your money, as suggested by open-ended funds in this sector, is an illusion. The Bank of England is now reportedly considering intervening, by perhaps imposing enforced notice periods before redemptions, or boosting liquidity requirements for funds (forcing them to hold more cash or easily saleable assets, for example).
But there's a simple way for investors to avoid this worry in future: we have always recommended that you choose investment trusts (closed-end funds) to play this sector even if there's a downturn or a rush for the exits, you'll always be able to sell if necessary, even if it's at a big discount.
How exposed are the banks?
In the 2008 crisis, one reason many banks struggled is because they had loaned so much money against commercial property. When prices in the sector crashed by more than 40% from peak to trough the banks were left holding bad debts secured against properties that were collapsing in value.
This time around, the big banks have far less exposure, according to the Bank of England. Bank lending to commercial real-estate companies has roughly halved, from £150bn in 2011 to £85bn now. Banks have also significantly raised their capital reserves in an effort to make themselves more resilient. RBS and Lloyds Banking Group (both still partly owned by the taxpayer) are most at risk from falling prices, according to JPMorgan.
RBS currently has £25.2bn of commercial property loans on its books (worth around 66% of its tangible net asset value, a key measure of capital), while Lloyds has £18.1bn (around 46%). But overall exposure is "manageable".
Meanwhile, the Bank of England has warned that small banks and building societies, including challenger banks, are the most vulnerable to a post-Brexit downturn, as they have made the most risky loans to the sector. Overall lending is smaller (£17bn in total), but loan-to-value ratios are higher, with a third lending at loan-to-values of about 70%.
In other words, it would take a smaller fall in prices to put these loans into negative equity. Overseas banks are also fairly heavily exposed to UK commercial property, making 42% of new loans in 2015 (just above 2007 levels), according to a survey by De Montfort University.
Yet in all, if there was a genuine economic shock, commercial property would account for "only a fraction" of banks' impairments, says Lionel Laurent of Bloomberg. "More concerning" are the impairments seen in mortgages, non-mortgage consumer lending and loans to businesses. In short, we only really have to worry if there's a more general slump in the economy.
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