Why the search for yield may call for some home comforts

Chancellor of the Exchequer George Osborne's decision to buy back the remaining War Loan is the one policy to emerge from the Autumn Statement (3 Dec ’14) that still attracts surprisingly little attention. The Government will return the £1.9 billion principal to owners of the 72-year old bond next March. This might not seem like a big deal, but when the Chancellor believes buying back a perpetual bond that yields 3.5% looks like value for money, clients and their advisers might just take the hint that Mr Osborne does not expect interest rates or the prevailing 2.0% yield on ten-year gilts to rocket higher anytime soon.

What might be a chance to cheaply refinance debt and good for the Chancellor is therefore not necessarily welcome news for income-starved clients who are looking for juicy coupons or dividend payments to help them build a worthwhile savings pot. The quest for yield will surely therefore remain a key investment theme again in 2015 and one area which may have the potential to deliver is real estate.

The Government will redeem the £1.9 billion, 3.5% War Loan in 2015

Source: Thomson Reuters Datastream

For clients, real estate investment usually means commercial property, an asset class which can be accessed through individually quoted Real Estate Investment Trusts (REITs). The sector has done well in 2014 but still offers some respectable dividend yields and also scope for capital appreciation, judging by the strong net asset value (NAV) uplift offered by British Land, Shaftesbury and Great Portland Estates, amongst others, during the autumnal reporting season.

The Real Estate Investment Trusts sector has done well in 2014

Source: Thomson Reuters Datastream

...and ranks second year-to-date among the 39 sectors which comprise the FTSE All-Share index

Source: Thomson Reuters Datastream, AJ Bell Research. * 1 Jan to 9 Dec 2014.

Clients may prefer to avoid stock-specific risk and obtain any property exposure via a collective. Thankfully there is a good choice of open-ended funds which address the British commercial property industry. The best performer on a five-year view of those funds available on the AJ Bell platform is Henderson UK Property, run by Ainslie McLennan, one of the speakers at last month's very successful AJ Bell Investival in London. It offers a 12-month yield of 4.9%, according to the Morningstar data, a figure which could be enough to satisfy some income-hungry clients.

Top performing UK property funds over the last five years

Source: Morningstar, for Property - Direct UK category. Clean funds only.Where more than one class of fund features only the best performer is listed.

There is a further angle which clients and advisers may like to investigate. The £29 million TM Hearthstone UK Residential Property fund provides access to the buy-to-let market. The collective therefore spares clients the time and aggravation – let alone the borrowings – which can accompany a buy-to-let investment and offers greater geographic diversity too. It is eligible for Individual Savings Accounts (ISAs) and Self-Invested Personal Pensions (SIPPs) and chief executive Chris Down explains the current gross rental yield on the portfolio is 5.5%, excluding maintenance and management costs, fund level expenses and the 90 basis point (0.9%) annual management charge. The fund reaches its third birthday in summer 2015 and its profile could start to rise among the adviser community as it seeks to build a track record of solid returns, pending any unforeseen upset in the housing market.

The REIT stuff

To preserve their preferential tax status, REITs must distribute at least 90% of their net income to shareholders as dividends. This naturally brings them to the attention of income-seekers and based on consensus estimates the FTSE 100's four REITs, Land Securities, Hammerson, British Land and Intu offer prospective dividend yields for 2015 of 2.8%, 3.5%, 3.7% and 4.0% respectively.

More than a dozen other property and property services plays grace the FTSE 250 while the junior AIM platform’s biggest constituent by market capitalisation is Songbird Estates, the owner of Canary Wharf. It is the subject of a contested bid, a development which provides further evidence of how capital inflows are supporting the valuation of British commercial property assets and especially offices in London.

AIM-quoted Songbird is trying to fend off an overseas bidder

Source: Thomson Reuters Datastream

Some REITs specialise in London offices, others are experts in retail and industrial sites, while some are more exposed to the rest of the UK. Clients and advisers may not have the time or inclination to analyse the different business mixes of the firms in question and it is here than a good fund can come in to its own.

Standing tall

In her presentation at the AJ Bell Investival, Henderson UK Property’s Ainslie McLennan explained how she looks at location, quality of tenant, lease duration, lease structure and a building’s specifications when deciding whether an asset merits inclusion in the £2.2 billion open-ended investment company (OEIC). The portfolio, whose mandate is to deliver capital gains and a steady income, currently comprises 84 properties with over 400 tenants, with a 32% weighting toward offices, 29% in retail and 16% in industrial. London suburbs provide one area of geographic focus although McLennan also spoke positively about distribution sites in the Midlands.

The UK’s limited land bank and tight planning regulations should help underpin the commercial property market in the long term, although the same can be said for the residential arena too, even allowing for cyclical lumps and bumps. It is quite possible that some clients have turned their hand to the buy-to-let market directly but those without the time or appetite for the administration involved now have the option of letting a fund do the donkey work for them.

The TM Hearthstone Residential Property Fund seeks to deliver returns from a mix of capital value and income, with the income coming from lettings under Assured Shorthold Tenancy agreements (ASTs). On a trend basis, fund manager David Gibbins and his team are looking to provide mid-to-high single digit returns on an annual basis.

UK house prices are still rising, albeit at a slower rate

Source: Thomson Reuters Datastream

Some of the steam may be coming out of the top end of the London market following the Autumn Statement’s changes to Stamp Duty Land Tax and a stunning rise in valuations but the OIEC does not play at such exalted levels. It buys new houses and flats direct from the housebuilders, in bulk with a discount, after detailed analysis build quality of the dwellings themselves and their location.

At the time of writing 38% of the 125-dwelling portfolio can be found in Greater London, 21% in the South East and the balance across the rest of the UK, where it is split roughly 50-50 between apartments and houses. There is no preference between brownfield or greenfield sites, although the former tend to be in good locations.

Besides being an OEIC authorised and regulated by the Financial Conduct Authority (FCA) the collective is also a designated Property Authorised Investment Fund (PAIF). This brings the sort of tax advantages enjoyed by REITs. Capital gains and income are tax-free and the only levy to which the fund is subject is Stamp Duty Land Tax.

Stay liquid

Void rates are currently in the very low single digits at both the Hearthstone and Henderson collectives. They also have something else in common, in that both run sizeable cash positions. Many clients were unable to withdraw cash from professionally managed commercial property funds when the financial crisis of 2007 struck owing to the illiquid nature of the underlying asset. Some funds even imposed redemption limits or freezes when the market turned sour, as they were unable to sell quickly enough or at an acceptable price.

Fully aware of this, McLennan has nearly 16% of assets in cash or liquid securities (REITs) and Gibbins some 8%, while the latter also has a borrowing facility which is kept in reserve for the event of a sudden rush of redemptions, to provide potential investors with some welcome reassurance.

Russ Mould, AJ Bell Investment Director.