Is UK property overheated?
[Estimated time to read: 6 minutes]
We ask Nedgroup Investments Growth MultiFund managers Simon Watts and Andrew Yeadon why they continue to like UK property and where their equity exposure comes from, in part two of our fund manager Q&A...
Simon and Andrew, the fund currently has a high equity exposure at around 77%. What is the highest exposure to equities you would expect to have in this portfolio? Likewise, the fixed income portion of the portfolio is currently very small at around 2% – is this a normal weighting towards fixed income?
I could go to 100%, but, in practice, over the last three years the highest equities have been was 93% if you include REITs. As mentioned in part one, the Growth MultiFund will normally have a strong bias towards the riskier asset classes, with equities being the most significant.
Equally, bonds and cash will typically be low. A normal position for the two combined would be 10%, which is roughly where we are right now, although most of that amount is sitting in cash, with only the 2% you mention currently allocated to bonds.
Within the equity portion of the portfolio, the Vanguard Global Stock Index fund, a passive strategy, makes up 19%. How long have you held this position and what do you like about this fund?
We’ve held it for a few years, although the weight varies. Having some passive exposure really helps when we make asset allocation changes, as we prefer to trade these vehicles rather than the active managers. We really like Vanguard in the passive space because they are the lowest cost player and their products track the relevant indices very closely.
Property also makes up a sizeable chunk of the portfolio at around 11%, made up of two positions – the F&C Commercial Property Trust and the iShares Developed Markets Property Yield Fund. What do you like about property?
That’s actually two questions, because the first exposure is to UK commercial property, whilst the second is to global property securities.
On the first, even though we have held it for a few years now, we still like UK commercial property because it offers a good yield, and also because we expect capital values to continue to rise. The recovery in UK commercial property valuations over the last couple of years has been investor-led, and has largely reflected “yield shift”. It started in London prime, and rippled out to the regions and into secondary.
With average yields now having been driven down to about 5.3% (according to the IPD Property Index), the investor/yield shift part of the property story is fading. However, that shouldn’t mark the end of the UK commercial property recovery because rents are starting to pick-up strongly after a long period of very little growth.
One of the legacies of the Great Financial Crash is that we saw a big slowdown in construction activity which has led to a shortage of available commercial property in some important markets. As a result, landlords are now finding it much easier to raise rents when leases expire.
So if we consider the income and rental growth together, even assuming flat yields, we can easily get to a total return of 7 to 8 percent per annum for UK commercial property over the next couple of years. We think that looks pretty solid in a world where cash rates are near zero, and UK 10 year government bonds yield only 1.8 percent.
On global property securities, we have a more neutral allocation. It’s quite normal for us to include an allocation to property securities in our portfolios, if only because they offer some diversification benefits, although obviously the weight will vary depending on valuations. Our neutral stance balances the reality that, whilst global property security valuations are reasonable, the asset class is interest rate sensitive and can sometimes overreact to rate changes.
The F&C trust is particularly focused on the London property market. Do you have any concerns about that market being overheated at all?
Running global multi-asset portfolios, there are always plenty of things to worry about. But to be honest, F&C Commercial Property (FCPT) isn’t something I lose any sleep over. We hold it as a quality long-term play on commercial property.
It is true that the London commercial property market has been very strong over the last few years, and that there are some signs of overheating. But I don’t worry too much about FCPT because their main holding in London is St Christopher’s’ Place, which is a fantastically located block of small retail/restaurant outlets near Selfridges. It’s a unique property asset that they could sell tomorrow for way more than it is valued at in their books.
So whilst we hear stories of crazy prices being paid by investors for some London property, I’m very sure that those types of prices are definitely not being used by the independent valuers when they calculate FCPT’s net asset value, and in that sense, there is a decent margin of safety built in. The management and board of FCPT have a long history of being very conservative, which we like.
One point I should add though is that because FCPT’s assets are mostly prime and its gearing is very low, it’s quite likely that its net asset value growth will not be as fast as some of the riskier/lower quality funds that are still playing catch up. But even so, I’m still quite confident that FCPT will do fine for the foreseeable future, whilst paying us a healthy monthly dividend along the way.
I note that the four biggest sector allocations are – consumer discretionary, financials, IT and health care. How “sector aware” are you in terms of fund selection? Do you choose funds specifically to target a sector, or is the sector allocation more secondary to other factors?
We monitor it, but we see it as a by-product of the decisions made by the underlying managers. Understanding what is going on at that level is important and we take it into account when we are thinking about how the portfolio might behave and its total risk. For instance, if we know that our underlying managers are taking more risk within their own portfolios, we may consider offsetting some of that exposure by reducing our allocation to them.
We experienced a period of increased volatility during Q3 2015. What did you do during this period? Did you use the short term wobbles to add to positions?
Very little to be honest. Of course, there were lots of meetings and discussions. We set some target levels for when we would commit more cash to risk assets, but those targets didn’t get triggered. Even though markets have bounced back nicely, and our portfolios have performed well over recent weeks, we remain of the view that now is a good time to hold some cash in reserve.
Are you anticipating more volatility as we head towards the end of 2015?
Yes, but it would be easy to get too carried away with fear having just experienced quite a nasty spike in volatility through August and September. The fact is central bank policy will remain very supportive of risk asset values. At the same time, some key asset classes, such as US stocks and government bonds are pretty fully valued, in our opinion. Taken altogether, we think that we have moved into more choppy waters, with question marks over the outlook for growth and divergent monetary policy likely to remain destabilising influences.
Are there any new funds you are considering adding at the moment?
Yes, we are looking closely at a few things, particularly in the investment trust space…but I can’t give details as Nedgroup’s Compliance Team would be all over me if I talked about them prematurely!
About Simon Danaher
Simon Danaher previously worked for AES International, in marketing and communications.