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Property: moving on from the mainstream

Property investors are starting to increase allocations to alternative sectors in search of income resilience. Does this make sense?

Shops, offices and sheds: the three cornerstones of commercial property investment. From these bricks and mortar holdings an owner might expect to receive long, predictable income streams and (hopefully) an appreciation in capital values.

But do they? The capital side of the investment equation has certainly been giving some owners of property sleepless nights recently. With shortening lease lengths, more break clauses and greater incentives being offered to tenants to sign leases (such as rent-free periods), commercial cashflows are becoming increasingly volatile – and that’s before we even consider voids! So perhaps it is not surprising there is now a widening divergence in sector composition across property portfolios.

There is now a widening divergence in sector composition across property portfolios

We are seeing increasing evidence of investors reweighting towards more income-resilient areas and away from those under stress, such as the retail market. In fact, analysis of the MSCI IPD Property Index suggests that the allocation towards defensive sectors – in this instance, industrial and non-commercial (alternative) property – is at its historical peak.

The case for industrial property is a whole different blog topic, so let’s think about alternative property. By definition, the easiest way to define this sector is anything that isn’t a shop, an office or a shed. But isn’t this a little too reductive? There is more to this market than just being the 'opposite' of commercial property. It encapsulates the broadest spectrum of buildings, from hospitals to homes and everything in-between. Importantly, I think it’s where we can best align our aspirations to invest patient capital with the long-term needs of society.

But let’s take it back to basics. Property investments generate income, and income is important. It boosts performance, can hedge against a range of outcomes and, ultimately, is what we give back to stakeholders. This means that predictable cashflows are just as important as attractive cashflow: rent and revenues that are the right amount, paid at the right time – and hopefully for a long time. Yet as we’ve seen borne out across the UK’s high streets this is not always a given, so we need focus on resilience.

Investors should align their aspirations to invest patient capital with the long-term needs of society

Income resilience can be embedded into an investment strategy by acquiring assets where cashflows are less volatile than those reliant upon productivity and profits. Resilience is underpinned by long-term factors: an aging population, flexible lifestyles, a reduction in state-provided assistance or the need for more urban infrastructure.

On the ground, this means owning needs-based buildings that help solve the challenges in society today, or just make life a little easier. We believe that quality care is best delivered in quality healthcare buildings, for example. And that the structural change towards demand for purpose-built rental residential housing, whether that is family homes, retirement units or student halls, is here to stay.

To be clear: this is a not a replica of 2012’s notion of a ‘great rotation’ from bonds to equities transposed into commercial vs. alternative property. Not least because alternatives behave more like bonds and commercial property performs more like an equity investment!

We believe it is the strategic deployment of capital towards cycle-insensitive assets that will ultimately deliver resilience over the long term. View it as a subtle change in the risk profile to produce performance within an environment where the only certainty is for more uncertainty.

We believe it is the strategic deployment of capital towards cycle-insensitive assets that will deliver resilience over the long term

However, as the sector outlook becomes more polarised, allocating capital to target higher returns without increasing concentration risk is getting harder. Not all income is created equal, so we place greater emphasis on credit quality and take a proactive view on managing operational risk. This helps to limit the downside and allows for a more nuanced view on a potential investment.

Am I calling the end of investment into traditional forms commercial property? No. But adding in these types of assets to function as income stabilisers allows for investors to consider taking more risk elsewhere. So as the market works through its cycles I think it’s time to move on from the mainstream and consider the alternatives.

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