Why I’d still buy British real estate

The last few weeks have seen a dramatic turnaround in sentiment towards the UK's commercial property market. After Britain voted to leave the EU, investors panicked, worried about an imminent meltdown. Just weeks later, many of these fears had subsided.

One visible sign of this growing calm is the news last week that Canada Life has lifted the suspension of redemptions on its Canlife UK Property life and pension funds. The asset manager was just one of many firms that felt the need to slap on penalties against investors looking to liquidate assets in what is, ultimately, an illiquid asset class.

However, Canada Life's announcement contains a sting in the tail. The firm has imposed a fair value adjustment of 7% across its £450m property funds, to reflect the uncertainty of the post-Brexit market. If Canada Life and its adjustment are to be believed, the UK commercial property sector isn't entirely in the clear yet.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Looking back over the last few years, it's easy to see how much of a bull market UK commercial property has been in: it has returned an average of 11% per year since 2009, according to the IPD UK Monthly Property index. After such a strong run, it's not too surprising that the market was shaken by the vote to leave the European Union.

The IPD index for July showed that capital values fell by 2.4% over the month. The similar CBRE property index was down 3.3% in July, with the office, retail and industrial sectors falling 4.1%, 3.6% and 2.2% respectively. City offices were down 6.1%. This breakdown in returns between sectors points to what I think are some subtle and important trends. If any market was already looking a bit toppy before Brexit, prime City space must have been near the top of that list.

Post-Brexit, I'd say that's even more the case. In fact, I'd stay well away from any fund with big holdings in this space. A fund that has a more regional focus, especially on industrial property, is probably a better bet (exporters might benefit from the much cheaper pound).

Alan Brierley, a funds analyst at stockbrokers Canaccord Genuity, emphasises that even before Brexit the UK commercial property sector was "adjusting to a period of lower returns, which were expected to be driven almost entirely by income". I'd also be slightly concerned about tightening lending conditions and evidence that many real estate investment trusts (Reits) are selling down their most successful assets for big profits.

Balanced against this, most Reits have strong balance sheets and are managing to increase rents, albeit slowly. So overall, I think it's probably too early to call the end of the current property cycle. The motivations behind investing in property funds still exist, with the single biggest driver being the scramble for yield.

In a low-interest-rate environment, any real-asset-backed equity paying a regular, above-average income is always going to prove popular. Looking forward, although it's impossible to predict what will happen with the UK's decision to leave the EU, a strengthening UK economy should fuel demand for office space, as well as real estate in the residential and retail sectors.

However, you still shouldn't expect double-digit returns from Reits. The majority of funds will make most of their money from gently increasing their rental yields big capital gains are likely to be few and far between in the next few years. If you make perhaps 1%, or even 2% in capital gains in 2016, I'd say you were a very lucky investor indeed. But you should be able to bank a decent 4.5% to 5.5% income return.

In terms of actual Reits, I'd stick with my core fund ideas, including Schroder's Real Estate Investment Trust (LSE: SREI), Picton Property Income (LSE: PCTN), as well as Eurozone-focused Schroder's European Reit (LSE: SERE).