by Jake Moeller.
Lipper’s Jake Moeller reviews highlights of a presentation by George Gay, Fund Manager F&C Investments on March 19, 2015.
There will be few investors and fund managers who do not remember the terrific liquidity crisis that afflicted U.K. property funds in 2008. The suspension and swing-pricing of funds – first the smaller ones and ultimately the behemoths – caused considerable trauma to a market that had not seen material challenges to the value of the asset class since the early nineties.
An enduring legacy of this event was that property fund managers and investors alike are much more conscious of liquidity. Portfolios contain a greater number of smaller properties, sector and regional diversification is encouraged, and cash flows are carefully monitored.
Indirect property exposure via real estate investment trusts (REITs) and property-related company shares is another mechanism by which a property fund can increase liquidity.
F&C Property Growth and Income Fund is such a hybrid. The managers aim to maintain 40% of the portfolio in direct property, with the remaining 60% in property securities. Mr. Gay, who has been with F&C since 2005 and is primarily responsible for managing the physical assets of the portfolio, is quick to address the correlation of property securities “liquid bricks” and equities.
He concedes that the correlation between equities and REITs (measured with the FTSE All Share and the IPD 6-month forward) is high over short holding periods but he points out that this drops substantially after a year to under 0.2 after six years. Thus, REITs can offer considerable yield opportunities with direct property-like characteristics for investors with a longer-term horizon.
Table 1. Correlation of FTSE EPRA UK and FTSE All Share
F&C has an eight-person property team headed by the highly experienced Marcus Phayre-Mudge. The team is currently responsible for managing £1.3 billion of property assets over five funds, and it has two dedicated equity analysts undertaking over 100 company meetings a year to populate the listed component of the portfolio.
The fund is highly yield focused, aiming to deliver a 5% plus annual distribution yield. Currently, the physical property portfolio of ten buildings is yielding 7.8% and a high-conviction pan-European securities portfolio of some 40 stocks is yielding 4.0%. The fund was originally created in 2005, but it was then a Guernsey-listed vehicle and only in February this year has it converted to a U.K. regulated OEIC, although the portfolio and management style remain unchanged. Therefore, the track record of the original vehicle is still relevant for performance analytics; it aims to out-perform a composite 50% UK IPD Monthly/ 50%EPRA Europe ex UK Index.
Table 2. Performance of F&C Property Growth and Income from Inception (Guernsey Vehicle) in GBP vs Peer Group and IPD Index
The direct component of the fund is very actively managed and seeks to acquire buildings in the £3 million to £5 million range. While F&C likes to have long-term holding periods, it is not necessarily disposed to long-term leases; Mr. Gay prefers to assess the potential longevity of tenants rather than be “blinded” by a long-term income stream but with building tenants who are desperate to leave. Mr. Gay’s thesis is simple: People hate moving. They dislike dealing with utility and telephone companies and, he cites that 88% of his tenants stay on lease until expiry.
The average lease length of the portfolio is four years meaning that every year 25% of the leases are coming to expiry. Interestingly these two statistics work well for F&C. Under the RICS Redbook methodology the property valuers have to assume a worst-case scenario on lease expirations, i.e., that 100 % of the tenants will leave at the end of the lease rather than the 12% that actually do. Hence, F&C is constantly able to beat the conservative valuations of the Redbook.
Buildings are mainly in the office and industrial sectors (retail exposure is gained via the REITs component), with preferred geographical exposure to southern U.K. Currently, there is occupancy of around 91%, with some offers imminently expected on some of the vacancies. In the equities component, F&C is concentrating on key markets in Europe that are able to benefit from rental growth. These include a core of French offices, German residential exposure, some Nordic stocks, and some shopping centres.
Mr. Gay likes small property companies, since they are “better able to align with management” but he believes retail exposure has to be via large property companies such as the fund’s top holding, Unibail-Rodamco. “You need to have a large mix of tenants and a large leisure blend to be successful in the way that Westfield has been at Stratford and Shepard’s Bush for example.”
Table 3. Long Term Share Price of Unibail-Rodamco
Mr. Gay paints a favourable outlook for certain parts of the European property market presently, both from a fundamental and a valuation perspective. He sees a lack of supply and yield compression from equity (rather than debt) sources causing supportive “rental tension” in Europe, whereby after five years the market is to the advantage of landlords rather than tenants.
He still sees fair value in property securities as opposed to some European equities. REITs are still at discount to F&C’s one-year out forecasted NAVs, and Mr. Gay is also seeing growth in earnings coming about through both rent increases and favourable interest rates.
F&C Property Growth and Income Fund has exhibited a strong long-term track record and did not have to freeze redemptions in 2008. It has done this while keeping cash drag to a minimum (30% was the highest amount of cash held and then only at the birth of the fund in 2005). If you are happy to ride out short-term periods of high correlations between equities and property securities, then the liquidity profile of this fund also has to be attractive.
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This material is provided for as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice. The author does not own shares in this investment.