Infrastructure and real estate have had a good run. Should you get out now while the going’s still good, or hang on for the income?
The share prices of infrastructure and real-estate investment trusts and have shot up in the last few years – pushing yields down – and many investors could be forgiven for thinking they should get out while they are ahead and before interest rates rise. So is this as good as it gets for real assets?
Worrying valuations
I do think that infrastructure funds look the least appealing in terms of their fundamentals. According to Numis Securities, a broker, the average premium over net asset value (NAV) for the major equity-based infrastructure funds is now 11% (in other words, the funds’ shares cost more than the value of the underlying portfolio). Meanwhile, yields are down at 4.7% (infrastructure debt funds yield slightly more at 5.2%). In the last year alone the sector has gained 8.1% in price terms, with NAV growth of 11.3%. I own many of these funds, and I do find these valuations a bit worrying – but I don’t think we should sell yet.
Rising rates aren’t good for infrastructure investors. Valuation models in the sector depend on “discounted cash flows”, which are based on interest rates – the higher rates are, the lower the potential return. However, while rates might rise in 2016, I’d be very surprised if by mid-2017 UK rates were above 2%, let alone 1.5%. That’s not the end of the world. And demand for new infrastructure is not going away. As big players diversify, we’ll see more social and energy infrastructure, and more international diversification. So I’d hang on. In 2016, you probably won’t make much in the way of capital gains, but you’ll still pocket that 5% yield.
Near the top, but not there yet
On real-estate investment trusts (Reits), I’m more optimistic about the prospect of getting some limited capital gains as well as the yield (currently averaging around 4.5% for UK funds). The bears argue that leverage has picked up and there’s a mountain of loans to refinancein the next two years, just as a swathe of new City office developments is set to arrive. Meanwhile, rising rates will spell trouble not just for refinancings, but also for clients renting expensive property. Throw in the fact that UK institutions – including M&G and Aberdeen – have been selling more big office blocks than they bought for the first time in three years, and you have a worrying picture.
However, I don’t think we should be overly cautious on prospects for next year. According to the IPD, the main industry research body, total returns on commercial property came in at 1% during October, although the pace of both capital and rental value growth slowed. Capital growth was 0.5% (compared to 0.8% in September) and rental values grew 0.3% (from 0.4%). Net initial yields were largely unchanged at 6.12%. The best numbers were seen in the City, where capital growth was1.2%. Demand for property in central London “continues to outpace the ten-year average”, says Numis, with property in other parts of London enjoying strong rental growth “as the lack of space in central London locations drives occupiers… further afield”. So I don’t think we can call the top of London’s property cycle yet – although we can’t be more than two to three years away.
So far this year total returns for commercial property have hit 11.5%, (6.6% capital gains, 4.7% income).
I think we can expect lower returns in 2016, possibly 7%-8%, implying a yield of 4.7% and capital gains of 3% or so. But the sector has become cheaper. Earlier this year, most Reits traded at big premiums to NAV – but the average premium has fallen from 5% to 2.4%. If you factor in October IPD data, Numis reckons that’s fallen to just 0.8%. I think the key driver for investors now won’t be capital growth, but rental yield growth, as inflation makes a comeback. That could help Picton Property, Schroder Real Estate and UK Commercial Property, all of whom have a fairly active style, but whose shares trade at a discount.
One to buy now
It’s not too late to add an extra name to your core portfolio of Reits and infrastructure funds – the Tritax Big Box fund (LSE: BBOX). It builds huge out-of-town storage “boxes”, beloved of retail and transport giants. Clients include Ocado, Howdens and Tesco. Big boxes sound cheap and commodified – just build a 300,000-1,000,000 sq ft box near a motorway, then let it out. But in fact, they operate with quite sophisticated technology to satisfy online retail orders. Clients sign up for long leases (averaging 16.5 years) on yields between 5% and 6.5% (recent deals have come in towards the bottom of that range).
Demand is constantly growing. Tritax is by far the biggest player, with a relatively low cost of capital – currently 1.4% above three-month Libor (a key interest-rate benchmark), which implies that the interest bill will rise if rates do. The fund is on a premium of 4.8% – above average but not terribly so. It yields 5.1%, backed by an underlying property yield of 5.8% at the operating level.