Real estate value managers often get tarred with the brush that all they look for is high income returns. This is not something that AEW UK Investment Management, a UK value-oriented management group, would tend to agree with, regarding itself as more of a contrarian investor to that of its peers.
And over the last six years since it launched the AEW UK Core Property Fund in 2012, this approach has very much been to the benefit of its investors.
As of December 2017, the AEW UK Core Property Fund was the top-performing fund over 1, 3 and 5 years according to the AREF/IPD Index, locking in performance returns of 14.4 per cent, 12.2 per cent, and 14.4 per cent over those three time periods. That the fund returned the same over 5 years as it did over 12 months is testament to the asset management skills of the AEW team, who between them have been running core funds for 20-plus years and have over 100 years of combined experience. The changing composition of the portfolio over that time has been less about income return and more about capital growth.
“We focus on the underlying land for any given real estate investment,” says Richard Tanner (pictured), Managing Director of AEW UK Investment Management & Portfolio Manager of AEW’s UK Core Property Fund. ”How good is it, what is its long-term value, how many different options can it be used for? We look for large areas of land in conurbations that offer multiple uses, relatively cheaply. Then we add back in the value of the bricks and mortar and we add back in the income component. While we generally end up throwing off quite a high income return, it is not our starting point.”
Over the first three months of 2018, the fund added 2.5 per cent of investment performance, taking the rolling 1-year average return up to 14.5 per cent; this compares to a weighted average of 10 per cent and a median fund performance in the AREF/IPD Index of 10.8 per cent.
Currently, Tanner says the fund favours warehousing and alternative sectors and is underweight London, which the team does not regard as representing good value; at least for the next couple of years.
“Overall we are quite positive on the market,” says Tanner. “The real estate market is obviously a broad church, from ground rents through to city office developments, and within that, for a relative benchmark fund like the AEW UK Core Property Fund, we feel pretty optimistic.
“We are busy selling things well above valuation. We are still finding assets to buy that we think are attractively priced, and aside from accepting the Armageddon of the high street (House of Fraser announced it would be shutting 31 stores across the UK), the opportunities we see in different pockets are good. We see a lot of areas of UK real estate that, as long as the economy doesn’t completely smash into the crash barrier, we feel are quite well balanced and experiencing positive structural change; in particular warehousing.”
He says that warehouses have had a fair degree of yield compression the last few years, leading many people to believe that this sub-sector of the market must be getting expensive. Tanner kicked off his career doing rent reviews on warehouses in Bristol where he would typically see rents of GBP5 per sq ft in the centre of Bristol and until very recently, rents were still GBP5 per sq ft.
“So whilst yields have moved in, in many cases we are dealing with rental levels that have remained largely unchanged. Land supply is low but demand for alternative uses is high in city centre sites like Bristol. The supply tap isn’t likely to be turned on until prices or rents go a fair bit higher than they are presently. We saw the same thing with farmland, which didn’t move in value for 20 years or so, and suddenly the dynamics changed and it tripled in value. We think in the right locations, such as motorway conurbations, warehouse rents look fundamentally cheap with the supply/demand balance we currently see.”
The AEW UK Core Property Fund’s biggest regional weightings are in the West Midlands and the South West of England, with industrials accounting for one third of the fund (compared to 25.9 per cent in the benchmark index) and offices accounting for just over 22 per cent of the fund (compared to 25.4 per cent in the benchmark index).
One of the fund’s Q1 acquisitions, London East Leisure Park, Dagenham, offering an attractive net initial yield of 8.8 per cent, is a good example of the investment philosophy Tanner referred to earlier. This particular site is a freehold leisure scheme that has been earmarked for residential development by the local council.
“Knight Frank and Savills have told us the site is worth two or three times the price we paid for it. We like the long-term fundamentals. The leisure park is generating high single digit income returns from solvent tenants etc. We look at the long-term value of the asset and then work backwards, which can lead us into leisure assets and scruffier bits of the UK warehousing sector. We are buying something at the moment whose land value is probably higher than the investment value. “
“That’s really how we look at investment opportunities,” explains Tanner.
A number of RE value managers have become a bit more like index tracking funds over the last few years in his view, noting that there aren’t many managers “who are willing to take positions against the benchmark”.
“We take two or three positions against the benchmark at any one time. Not many managers really are that value orientated,” he says.
As for alternative sectors, Tanner says these could include assets ranging from nursing homes to student accommodation, and indeed leisure parks: basically anything that doesn’t fit into traditional office/commercial and industrial sectors.
“Within the core fund, what we are finding among alternative sector assets like the London East Leisure Park, is very interesting site plays with attractive characteristics attached to them because they’ve been in a particular use for 15, 20 years or more.
“The direction of travel for us is slightly more towards acquisitions in the retail sector, where we see alternate use value stacking up; broadly in the south-east of England. Increasingly, retail for us is where we have an insurance plan it will be used for something else, such as residential developments. Where we don’t have that insurance plan, we are lightening our exposure. We are positive on industrials, neutral on commercial offices and we are negative on central London. Although I’m sure we’ll revisit commercial opportunities there in a year or two,” explains Tanner.
The current distribution yield for the fund is around 6 per cent on an annualized basis. Between September 2013 and September 2017, the distribution compressed from 10 per cent to 4.7 per cent, and London didn’t buy or sell is likely to climb back up to around 7 per cent by September 2020. Every time assets are liquidated in the fund and the team waits to reinvest the cash, this has a depressed effect on the distribution yield.
“In the early days of the fund, we were buying many buildings that were at the time over-rented, so the distribution yield was artificially inflated. We bought buildings that had an 18.8 per cent initial yield, re-based the rents (which reduced the yield) and moved on from that. Coming out of that period, we therefore had a number of buildings that gave us an artificially high distribution yield,” remarks Tanner.
Looking ahead, he says that although he is pleased the investment philosophy has proven its value over the last six years, it’s really the next six years that count.
“We’re focused on moving things around in the portfolio, liquidating some successes and teeing things up for the future”.
“We think there are some interesting long-term plays coming out of retail, the warehouse sector has a structural undersupply characteristic, which we like, and rents are so low that nobody can build anything at these levels. The economy seems to be strong enough for our purposes and we are reasonably happy with the direction of travel,” concludes Tanner.
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