• Income dominates the total return over the long term.
• Diversification is key to capturing varying sector performance.
• Industrials should continue to outperform in 2018.

For many of us, a house will be the most valuable asset we will ever buy and subsequently all our eyes are being drawn to the many press articles focusing on 2018 residential house price growth being flat. In commercial property a similar story is playing out: strip out the stellar performance posted by the industrial sector (as measured by the IPD Monthly Industrial Index, with a 21.1% total return over 12 months to end Dec 2017) and for 2018 commercial property returns are once again looking reliant upon the long-term core component of the total return, income.

In this respect the UK market has continued to benefit from sustained investor in-flows, both foreign and domestic. Commercial property is essentially an income proposition, as evidenced by total returns over the long term: 71% of the return from the IPD Monthly Index over the period 2000 to end-December 2017 has been generated from income, and those that treat it in any other way often get it wrong.

INVESTMENT PROCESS: DIVERSIFICATION IS KEY

Our investment process hunts out value, but focusing solely on a yield-centric bottom-up approach is a minefield, so it is important that once we are drawn to the highlights of a prospective opportunity, we heavily research its micro market. Variables such as supply, demand, market rents, infrastructure and demographics are the initial drivers of our decision-making process.

This routine is streamlined by our perspective advantage in that, across all our strategies, we own approximately a third of the IPD monthly index (in terms of number of properties). Our in-house data enables us to expedite the research and respond to vendors quickly. Buying long let, large lot sizes can be safe, but comes at a price typically linked to a low yield reliant on rental growth.

Given that performance between property sectors continues to differ significantly, diversification is key. Threadneedle UK Property Authorised Investment Fund (TUKPAIF) has an average lot size of about £6 million, so instead of making a few sizeable investments, we seek multiple assets with income spread across multiple tenants. Growth continues to be supported by the industrial sector, which generated a Q4 total return of 6.4% (and 4.8% in Q3 2017), while the retail and office sectors remain broadly flat in capital terms, generating quarterly total returns of 2.5% and 2% respectively (and 2% and 1.9% in Q3 respectively).

Figure 1: IPD monthly index total return

Source: IPD UK Monthly Index, as at 31.12.2017.

These trends were witnessed across the year as a whole, with industrials delivering very strong total returns of 21.1% against more modest returns of 8.5% and 7.7% in the office and retail sectors respectively. Outperformance by the industrial sector has been driven by well-documented structural shifts in occupational supply/demand patterns (ie, commerce growth combined with a loss of industrial land to alternative uses) generating rental value growth of 4.9% over the course of the year. This has attracted investors and consequently placed upward pressure on asset pricing, with yield compression contributing significantly to annual capital growth of 14.7%. A further contributory factor has been rising construction costs in the industrial sector creating headroom between prevailing rental values and the economic rent at which fresh development can be supported.

We avoid speculative development, so rather than knocking down and rebuilding, we prefer to implement top quality refurbishment programmes as a low-risk method of enhancing latent value. Buying with this mentality, an investor can benefit from the same microclimate investment strengths as the low-yield buyer - but often with a better income return and without the strict requirement for rental growth.

We try to avoid being blinded by the bright lights of London, looking beyond the capital to find better value. To that end, we search the UK to uncover properties that offer good value and the potential to generate a steady income yield, spreading our risk across a range of holdings. Instead of overly focusing on sector or location, we prefer to weigh up the merits of each potential deal, prioritising markets with a low vacancy rate to increase the re-letting prospects should a tenant vacate their unit. In summary:

• We are flexible buyers rather than buyers of 'trophy assets'.
• Active asset management is integral to our process as it creates and protects value and income.
• Good stock picking is an essential part of strategy implementation.
• We avoid high-risk speculative development. Refurbishments are comparatively quick and a low-risk method of enhancing latent value.

Figure 2: TUKPAIF property type overview

Source: Columbia Threadneedle Investments/IPD, as at 31.12.2017. Figures shown are a percentage of direct property assets.

OUTLOOK: UNCERTAINTY OVER EXTERNAL FACTORS

Changes in property values are typically driven by factors outside of property, be it political uncertainty or the behaviour of other asset classes. A standout example would be the 2007 liquidity crisis. The subsequent crash and resultant 'dash for cash' for many institutions created an oversold position: as liquidity was reallocated to the commercial property sector, the market experienced a spike in capital value growth of 16% over a 24-month period¹ at a time when property was fundamentally weak. In some markets rental values were in freefall. So a buyer of sustainable income will benefit from long-term performance and experience similar rises (and falls) in values as the low-yield/prime buyer.

While the greatest number of value opportunities can be found when property owners are in 'sell mode', it is important to remember the importance of short-term liquidity and having the stock in your armory that can quickly react to a 'sell requirement'. Often, central London is confused as the highly liquid element of a portfolio, but it is a high-multiple sub-sector with, in the main, volatile rents. This often translates into high-end lot sizes of interest to a limited target audience, and ironically could behave as an illiquid asset in a must-sell situation.

Looking to 2018, we expect industrials to continue to drive overall performance, as the migration from high-street shopping to online drives the continued expansion of industrial distribution centres. Despite the yield compression witnessed over the past few years, the income yield of 5.1% offered by UK commercial property (IPD Monthly Index as at December 2017) remains attractive to investors. Occupational markets have thus far proven more resilient than was widely predicted under a 'leave scenario' before the EU referendum. While returns are moderate, the case for property remains compelling on an income-generative basis.

Given that the impact of the referendum has for now stabilised, there is strong liquidity in investment markets and fundamentals are sound. We are seeing low overall vacancy rates, constrained development outside of the City, and the market as a whole is not highly leveraged.

Low gilt yields and interest rates will continue to enhance the appeal of property's income yield, and the continued relative weakness of the pound remains attractive to overseas investors, meaning there is significant equity seeking exposure to the UK market. As such we retain a defensive position, with no exposure to property-level debt, speculative property development or shares in property companies.

The TUKPAIF benefits from a well-balanced portfolio offering a high-income return, and is free from the elevated risks associated with speculative development activities. Following a period of significant growth due to sustained net investor inflow, it has a NAV of £1.39 billion as at 31 December 2017 and a 6.3% net initial yield, and has consistently delivered a 120+ bps income yield advantage (compared to the IPD Monthly Index) across its property portfolio over one, three and five years.

¹IPD Monthly Index capital return from August 2009 to July 2011.

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