By Annabel Brodie-Smith
“Uncertainty and expectation are the joys of life. Security is an insipid thing.”
These words were written by William Congreve, the English poet and playwright, who lived from 1670 to 1729, but they seem just as appropriate now. Yet again politics has come to the fore as the UK comes to terms with the unexpected news of a hung parliament.
Political uncertainty seems to have become the status quo but it’s comforting that equity markets currently, at least, appear to be taking the news in their stride with the FTSE 100 closing at 7,419 on the 15th June.
Surprisingly, three members of the Bank of England’s Monetary Policy Committee, out of the eight voting, wanted to raise interest rates this month. We'll have to see how this develops, but it continues to look like interest rates will remain low for the foreseeable future so this month we are taking a look at investment companies which generate income by investing in alternative assets, namely infrastructure and property.
Open-ended property funds suffered considerable problems after the referendum, with a number suspending trading, which meant investors could not buy or sell these funds. This situation highlighted the advantages of the closed-ended structure for an illiquid asset like property or infrastructure.
Investment companies are listed companies on the stock exchange so investors can always buy and sell shares freely. Investment company managers do not have to manage inflows and outflows and can take a long-term view of their portfolios, without being constrained by the illiquid nature of the asset class.
Although investment companies’ share prices dipped after the referendum, they continued to trade and swiftly recovered, with the Property Direct - UK sector up 18% over the last year. You can read the views of Will Fulton, manager of the UK Commercial Property Trust, who gives his view on the fallout from the Brexit vote and is positive on the outlook for UK commercial property despite the ongoing political uncertainty.
You can also read about our response to the FCA’s illiquid assets paper including our thoughts on the problems of the open-ended property funds and see a compelling comparison of open-ended and closed-ended property fund returns.
"Political uncertainty seems to have become the status quo"
– Annabel Brodie-Smith, AIC
Infrastructure has proved to be a popular sector for income seeking investors over recent years, with a current yield of 4.7%, and the sector has grown rapidly in size. HICL Infrastructure was the first infrastructure investment company to launch in March 2006, raising £250m but has now grown to £2.38bn, the eighth largest investment company. The infrastructure sector has grown from strength to strength and is now the fourth largest investment company sector.
Read our release to find out where managers are finding current opportunities and the outlook for the sector, and find out more about infrastructure by watching our film where I talk to Harry Seekings, Director of InfraRed Capital Partners, Investment Advisers to HICL Infrastructure, and Greg Taylor, Co-Portfolio Manager of Sequoia Economic Infrastructure Income.
See you next month and let’s hope the summer weather continues.
Communications Director, AIC
The future is Real
By Will Fulton, UK Commercial Property Trust
Will Fulton, Manager, UK Commercial Property Trust
After a difficult 2016, UK commercial real estate has started 2017 in a much more positive fashion. Capital values have moved back into positive territory, while rental growth has remained stable and investment activity has picked up. So, what has driven real estate’s recovery and what can we expect next?
Certainly, the second half of 2016 is a period many UK real estate investors may want to forget, as the fallout from the EU referendum hit. Market returns dipped and many investors, particularly private investors, reduced their exposure to the asset class because of a lack of clarity over the economic and political direction.
Stability despite the EU referendum
Amid this uncertainty, the UK Commercial Property Trust held up relatively well. Fourteen out of 16 lease negotiations it had in progress immediately before the EU referendum concluded on the same terms after the result. Importantly, the trust’s closed-ended structure meant that, while the share price experienced some volatility, it continued to offer liquidity throughout and this without the need to sell assets.
"The trust’s closed-ended structure meant that, while the share price experienced some volatility, it continued to offer liquidity throughout and this without the need to sell assets"
– Will Fulton, UK Commercial Property Trust
Having successfully weathered this storm, we are now in a position to look to the future with relative confidence. The dire economic consequences that many predicted in the aftermath of the referendum result have failed to materialise. With historically low interest rates and bond yields, investors continue to look elsewhere for income.
In this environment, real estate’s elevated yield compared with most other asset classes remains a key attraction.
Industrial property favoured as London offices dip
The macro view from Standard Life Investments is that politics will continue to dominate headlines in 2017, economic growth is likely to be subdued, and some further inflationary pressure may be seen. Against this backdrop, current indicators suggest reasonable positive returns from UK commercial real estate in 2017.
From a sector perspective, industrial property is preferred (industrial estates and logistics warehouses). The shift by consumers towards online purchasing, which has caused a significant increase in demand for warehousing space by retail businesses, should help deliver real rental growth.
Conversely, the outlook for Central London offices is less positive. Returns from this sector were slowing pre-referendum. However, the result has brought additional uncertainty and downside risk, with businesses here most exposed to potential regulatory restrictions on European trade reducing demand for office space.
Lowering allocations to London offices
Recent activity within the trust reflects these views. Prior to the referendum, we sold two properties – Arlington Street in London’s West End, and Dolphin House, Sunbury – which reduced the trust’s exposure to London offices. The sale of 13 Great Marlborough Street, Soho, London, followed in January this year, at a yield of 3.3% and ahead of its year-end valuation.
We reinvested part of these sale proceeds in a £22.8 million forward-funding commitment to acquire an industrial distribution unit in Burton upon Trent. Due to complete in July 2017, the unit was fully pre-let and will generate a yield on cost of 5.8%.
Elsewhere, the retail sector requires careful consideration. Inflationary pressures may prove a significant headwind. This could mean more pronounced polarisation within the sector between good and bad properties (in terms of location, income length, and tenant strength).
Therefore, stock selection will be vital in delivering strong returns. During 2015 and early 2016, we reduced the trust’s exposure to the retail sector by 10% while increasing exposure to the industrial sector.
An attractive outlook, particularly for income seekers
In summary, UK commercial real estate remains a strong proposition for investors despite ongoing political uncertainty. While capital growth is likely to be subdued this year, the sector’s generous income-generating ability will be the main driver of returns. As a result, the asset class is particularly appealing for those seeking a stable, regular income.
With an attractive 4.1% dividend yield (as at 19 April 2017), the UK Commercial Property Trust is well positioned in the current environment. It contains a portfolio of prime assets geared towards income generation and we remain focused on adding value through asset management initiatives.
In addition, the trust has a strong balance sheet with low gearing and considerable financial resources available to take advantage of further investment opportunities. One to consider for those investors looking to add real estate and its many benefits to their portfolio.
"UK commercial real estate remains a strong proposition for investors despite ongoing political uncertainty"
– Will Fulton, UK Commercial Property Trust
Responding to the FCA's illiquid assets paper, the AIC makes the case for closed-ended property funds
The AIC responds to the FCA's illiquid assets paper
"On performance grounds alone, there is a compelling case for investment companies when investing in illiquid assets"
Following the FCA discussion paper ‘Illiquid assets and open-ended investment funds’ published in February, the AIC has issued a response recommending clearer disclosure of the risks posed by open-ended funds that invest in illiquid assets. The AIC also recommended that fund providers should explain why the chosen fund structure is appropriate for its underlying assets.
Ian Sayers, Chief Executive of the Association of Investment Companies said: “On performance grounds alone, there is a compelling case for investment companies when investing in illiquid assets. This is demonstrated by the substantial outperformance of the investment company Property Direct – UK sector in comparison to equivalent open-ended funds (see chart).
Closed-ended companies in Morningstar's Property Direct - UK sector have outperformed open-ended funds in the same sector over one, three, five and ten years. Source: AIC using Morningstar (to 31/3/17), unweighted average of % total return for all funds in sector, clean share classes used for open-ended funds.
“The structural advantages of investment companies were also brought starkly into focus by the Referendum vote, when most open-ended property funds had to take some form of action in the light of changing sentiment, including repricing and suspending redemptions. Investment companies were not immune from market pressures, of course, and we saw discounts widen in the immediate aftermath of the Referendum result, though these have recovered since. However, investors were still able to trade throughout this period if they chose to, instead of having to wait for months to sell.
“Even today, many open-ended funds are holding substantial amounts of cash to provide protection against redemptions, sometimes as high as 25% or more. This is particularly relevant for income seekers, as such balances will be earning very low returns, whereas investment companies can remain fully invested, delivering a higher yield.
“The arguments in favour of using the closed-ended structure for illiquid assets are so strong that you have to question why the open-ended sector’s assets in UK Direct Property are four times bigger than the investment company sector. So we are calling for clearer disclosure of the risks associated with a mismatch between the liquidity of the fund and its underlying assets, as well as asking fund promoters to justify their reasons for the fund structure chosen, and not simply to default to the open-ended option.”
The Property Direct – UK investment company sector has outperformed the equivalent open-ended property companies over one, three, five and 10 years on a share price total return basis. Over five years to the end of March 2017 the average Property Direct – UK investment company is up 105%, whereas the equivalent open-ended property company is up 32.2%. Over ten years to the end of March 2017 the average Property Direct – UK investment company is up 48.3%, in contrast to the equivalent open-ended property company which is up 20.3%.
"You have to question why the open-ended sector's assets in UK Direct Property are four times bigger than the investment company sector"
– Ian Sayers, Chief Executive, AIC
Strong yields, good growth: but can it continue?
At just 11 years old, the AIC's Infrastructure sector is now its fourth-largest. Can the sector continue to deliver the high yields investors expect?
HICL Infrastructure was the first infrastructure investment company to launch in March 2006, raising £250m. Eleven years later it has grown to be the eighth largest investment company with £2.38bn total assets under management.
The infrastructure sector has grown from strength to strength and is now the fourth largest investment company sector, consisting of seven investment companies with total assets of £9.45bn at the end of May 2017. The Sector Specialist: Infrastructure has raised nearly £1.2bn so far this year and over the last five years the share price total return for the sector is up 84% (to end of May 2017).
Annabel Brodie-Smith, Communications Director of the Association of Investment Companies (AIC) said: "The closed-ended structure of investment companies is particularly suited to illiquid assets such as infrastructure. Investment companies are listed companies on the stock exchange so investors can always buy and sell shares freely. Investment company managers do not have to manage inflows and outflows and can take a long-term view of their portfolios, without being constrained by the illiquid nature of the asset class.
VIDEO: Will demand be so strong for HICL if interest rates rise? (Harry Seekings, director, InfraRed Capital Partners)
“Infrastructure has proved to be a popular sector for income seeking investors over recent years and the sector has grown rapidly in size. With the sector having a dividend yield of almost 5%, it’s not hard to see why.”
Duncan Ball, Co-CEO of BBGI SICAV S.A. said: “Investor interest in the infrastructure sector remains very strong. In a low interest rate environment, PPP [public-private partnership] assets with stable, predictable, inflation-linked cash flows derived from creditworthy government or government-backed counterparties are seen as an attractive investment proposition by many investors. In addition, a greater acceptance and understanding of infrastructure as a mainstream asset class and key component of a well-diversified portfolio have caused more investors, especially those with long-dated liabilities to match, to increase their allocations to the sector.”
On Monday 15 May, the AIC hosted a media roundtable with Harry Seekings, Director, InfraRed Capital Partners, Investment Advisers to HICL Infrastructure; Greg Taylor, Co-Portfolio Manager of Sequoia Economic Infrastructure Income and Bernardo Sottomayer, Partner at 3i Group plc, Investment Advisers to 3i Infrastructure plc, to hear more about current opportunities, investor demand and the outlook for the sector. Their comments, along with Duncan Ball, Co-CEO of BBGI SICAV S.A. and Giles Frost, Director of INPP have been collated below.
VIDEO: Are your yields sustainable? (Greg Taylor, Co-Portfolio Manager, Sequoia Economic Infrastructure Income)
Where are the opportunities?
Harry Seekings, Director, InfraRed Capital Partners, Investment Advisers to HICL Infrastructure said: “InfraRed Capital Partners, the Investment Adviser, is following a clear acquisition strategy for HICL which is focused on three core market segments: PPP projects, regulated assets and demand-based assets. Overall deal flow is reasonable but we find that the mix differs between geographies, e.g. secondary PPPs in the UK, regulated assets in the UK and Europe and primary PPPs in North America. Competitive pressure remains and pricing discipline is fundamentally important.”
Bernardo Sottomayor, Partner at 3i Group plc, Investment Advisers to 3i Infrastructure plc said: “We believe the infrastructure market offers attractive investment opportunities, although with interest rates still near all-time lows, demand, in particular for large regulated infrastructure assets, continues to be strong driving high prices and low projected returns.
“Against this backdrop, we are focusing on areas of the infrastructure market which offer better risk-adjusted returns, such as infrastructure businesses with some demand or operating risk. These businesses, whilst still displaying infrastructure resilient type cash flows, can be managed actively to enhance returns.
“3i has a long and successful track record of investing in these markets and its 25-strong investment team continues to selectively assess a broad range of opportunities across our key markets.”
Giles Frost, Director of INPP said: “Well-established regulatory regimes increasingly provide for an enhanced pipeline of investment in those operational and construction assets whose risks are mitigated by long-term, highly predictable and secure-cash flows in sectors such as waste water, utilities and energy distribution.”
Greg Taylor, Co-Portfolio Manager of Sequoia Economic Infrastructure Income said: “Sequoia continues to see good investment opportunities for the Sequoia Economic Infrastructure Income fund, which invests in economic infrastructure debt. The fund has a diverse portfolio of 44 underlying assets, including assets located in the US and Canada, the UK and Western Europe.”
Duncan Ball, Co-CEO of BBGI SICAV S.A. said: “A key component of our growth strategy has been to consider opportunities in creditworthy countries outside the UK. Often the competition is not quite as intense and more attractive pricing and terms can be obtained.
Often the competition is not quite as intense in creditworthy countries outside the UK, and more attractive pricing and terms can be obtained
“Another key component of our growth strategy will be to consider projects in the bidding/construction stage, as we believe the pricing on construction projects is more attractive on a risk-adjusted basis. Often the competition for construction assets is less intense as some investors require current yield, do not have sufficient and adequate asset management staff to oversee construction assets, or have mandates that restrict investment at this stage.
“BBGI has also used its strong PPP credentials to make it an appealing partner to construction companies who sometimes lack long-term ownership credentials, which are often required as part of the pre-qualification processes run by procuring government authorities. Using this approach, BBGI has been shortlisted for a number of opportunities over the past two years and will continue with this strategy.”
Outlook for the sector
Giles Frost, Director of INPP said: “The outlook for infrastructure investment in developed markets globally remains buoyant as governments increasingly look to private capital to fund high-quality, low-risk and long-duration infrastructure projects that in turn provide stable and secure returns to those investors seeking long-term income.”
VIDEO: Full panel discussion with Harry Seekings, Director, InfraRed Capital Partners (managers of HICL Infrastructure), Greg Taylor, Co-Portfolio Manager, Sequoia Economic Infrastructure Income and Annabel Brodie-Smith, Communications Director, AIC