Property Funds Struggle to Find Investment Opportunities

Property fund managers have been raising their cash allocation, partly to reduce liquidity risks but primarily because of a lack of attractive investment opportunities

Simon Molica 25 May, 2017 | 2:08PM
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Property and fundamentals are rarely put in the same sentence. Unlike most other asset classes, property is seen to be underpinned by esoteric demand that renders fundamental metrics - such as rental yield and debt to income ratios - worthless.

Yet, one cannot move away from the longer-term reality. Property cannot increase at a rate that exceeds its fundamental baseline forever. Either the prices must fall to reflect the fundamentals, or the fundamental baseline catches up via rental growth, population growth, wage growth, interest rate cuts or any other fundamental factor.

The stark reality is that property growth and fundamentals have to be linked in the very long-run and this is the challenge many property managers are said to be grappling with today. After decades of enjoying a tailwind to returns, the wind has seemingly stopped. This has seen many managers concentrating on raising their cash allocation even further, partly to reduce liquidity risks but primarily because of a lack of attractive investment opportunities.

The cash drag of property funds has hurt long-term performance against a fully-invested index

This lack of confidence among professional property investors is as startling as it is interesting. We find ourselves in a situation where the fundamentals face increasing uncertainty at a time when prices remain elevated – a recipe most valuation-driven investors seek to avoid.

The fundamental uncertainty is particularly evident in the working population and wage growth numbers. Specifically, from 1974 to 2014, the U.K. working population increased at an average of 139,000 people per year; achieved from a mix of the baby boomers, the rise of women in the workforce and more recently via strong immigration. Wage growth faced a similar tailwind, where real average wages approximately doubled from 1970 to 2008 despite inflationary pressures and a series of economic setbacks.

The trick here is not to predict, but instead acknowledge that the present dynamic is already looking quite different. We don’t know what will happen to the working population in a post-Brexit U.K., however we do know that the number of economically active 16 to 64 year olds has already flatlined since the Brexit referendum amid an ageing population and European outflows. We also know that average wage growth has slumped below the inflation rate since 2008.

The wage growth problem looks stable in nominal terms, yet weak in real terms

While the implications differ for residential and commercial property, the natural extension is to raise questions about one’s willingness to pay for ever-higher property prices if these fundamental pressures intensify. With the risks seemingly sloped to the downside, many property managers are now seriously pondering at what point the supply and demand dynamics may shift and whether the low interest rate environment will provide enough stimulus to offset such pressures.

This raises a series of dilemmas for property managers and individual investors alike. While one does not want to be overly fearful, one certainly doesn’t want to view the world with rose-tinted glasses either. In this sense, we advocate that investors intensely focus on the difference between market prices and their fundamental baseline, favouring lower-cost solutions and a willingness to hold for the long term.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Simon Molica

Simon Molica  is a portfolio manager for Morningstar Investment Management

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