Investors hoping to spot the early signs of another crash in the commercial property market should keep their eyes on UK ten-year gilt yields, according to Jonathan Webster-Smith, fund of funds manager at Brooks MacDonald.
Webster-Smith explained that a central attraction for property investors in the UK is the rental yield. But as the property market hots up and prices rise, those yields fall, dampening the income available to investors.
He believes the danger sign is when the yield on property falls below the yield on a ten-year UK government bond, an investment which is regarded as virtually risk-free.
He remarked that in 2007, ‘investors were looking at the income yield they were getting on property funds, and they were advised that, well you could get a higher yield by buying gilts [UK government bonds], and sometimes on a cash account. So investors went and moved out of property funds and into the higher-yielding product, which caused severe underperformance for property funds.’
Assuming Webster-Smith is right, the danger point is some way off. At the present time, UK gilt yields have fallen below 2 per cent, while most property funds offer a yield much higher than that.
But he noted that when UK interest rates eventually rise, gilt yields would be expected to go up too. This would narrow the gap between the yield on gilts and that on to property. If cash continues to pour into property funds at anything like the current levels, then Webster-Smith feels that a 2007-style crash could recur, where the yields on lower risk assets such as gilts exceed that on property, causing property investors who are focused on income to rush for the exit.
Webster-Smith has some exposure to property funds in his portfolio, with approximately 6 per cent of the capital employed in the funds he created for ‘low to medium risk’ investors in property, down to 2 per cent in the portfolio of funds he runs for higher risk investors.
Turning his thoughts to individual property funds, Webster-Smith remarked that he is a fan of the giant F&C Commercial Property investment trust, particularly as an income investment. But he remarked that he rates the fund a ‘hold’, rather than a ‘buy’ at the present time due to the 19 per cent premium at which it currently trades to its net assets.
Said Webster-Smith, ‘The performance of the fund on a total return basis is exceptional, I mean if you look at it on a performance line chart relative to the average fund in the sector, you would be forgiven for thinking that it invested in a completely different asset class to all the other property funds, it is so far ahead. We were able to buy it four or five years ago on a discount, and find it less attractive on the premium it is on now, but I am a big fan of the fund.’
Instead he is investing in two open-ended property funds, the £1.38 billion Legal and General UK Property fund, which currently yields 4.2 per cent, and the £500 million Scottish Widows UK Property fund.
Open-ended funds are valued at their net assets and cannot move to discounts or premiums.
In equity markets, he has, in the past three months, increased his exposure to the UK stock market, and is more cautious on the US.
Webster-Smith remarked, ‘The US economy looks to be in good shape, but the market there has performed very well for the past two years, and you would have to ask yourself if it can repeat that performance this year.
‘I think that there has been a big change, with the markets now expecting that US interest rates will rise faster than rates in the UK. For a couple of years the expectation was the other way around, and that could impact on the stock markets.
‘I think that part of the reason that the UK market did so badly last year was that the strength of sterling relative to the dollar hit company earnings, but now the dollar is stronger, so the earnings of the UK companies who sell their products in dollars should do better. Yet, the UK market went up on a total return basis by less than 1 per cent in 2014 and the market has started poorly in 2015, so the valuations aren’t more expensive even as the circumstances change.’