Quarterly Investor Report 30 September 2017

We have pleasure in providing our latest quarterly report where we explore the challenges facing the economy and the property market as the global political landscape changes.  In addition, we report the performance of Keills Property Trust as reported by MSCI.

Economics and strategy


30 June 2017

30 September 2017

10 year US bond yield (%)



10 year UK gilt yield (%)



 As the saying goes, “a week is a long time in politics” and as we went to press for our last quarterly report, it had just been announced that the Conservative Party had won the greatest number of seats in the UK General Election.  The snap election however was a disaster and removed the Conservatives’ overall majority, requiring them to join with the Democratic Unionist Party on a confidence and supply basis.  In the UK, the main issue of our time remains the imp  lementation of the 2016 Brexit referendum vote to leave the European Union.

We are now into October and Germany has elected Angela Merkel for the fourth time.  We were hopeful that with a renewed mandate, Merkel would be able to provide the necessary leadership to guide Europe though this uncertain period.  However, Merkel’s position has weakened and France, led by the newly elected President Macron, is picking up the leadership mantle.  Germany will of course sway the ultimate direction of Europe, but the much younger Macron has clearly got some of his own ideas for the future of the European Project including further fiscal integration and a Europe wide Army.


As we write, the Spanish constitution is being tested with the results of the disputed referendum which is claimed demonstrated a strong vote in favour of Catalonian independence.  For Spain and Europe the key will be how the existing Spanish and Catalan governments react.  Certainly, the obvious use of force by Madrid police does not engender sympathy for a so called democracy.  We would expect to see such behaviour in a little known African state and the world would rightly claim that the people were being denied the right to express their wishes through democratic means.  With regard to Spain, the comments from leaders of other countries, especially in Europe, will be interesting, but so far the silence is deafening.

It is not just Europe which is having problems politically.  In Japan, President Abe has announced a snap election and hopefully he will have a better result than our own Theresa May!

The revolving door at the White House on the other side of the Atlantic seems to continue to turn and this time Tom Price, the Secretary of State for Health has resigned.  At a time when various cuts are being proposed to the Obamacare package, he was chartering planes and jetting round USA.  Secretary of State Tillerson is also travelling, this time near North Korea where he seems intent upon calming down the war of words between North Korea’s Mr Kim and President Trump.  While at home in the US, Trump’s stated intention of reducing the corporate tax rate gave markets a boost.

Meanwhile, back in the UK, GDP is now at the bottom of the G7 and worse still, the outlook doesn’t look that great either.  Brexit uncertainties will not be going away any time soon and companies are stalling capital investment decisions until they can see the way ahead.  We believe that it is likely that GDP growth will reduce further and there is 50/50 chance of a technical recession during the next year.  The Bank of England has been keen to warn that the next movement in interest rates is likely to be upward and markets have taken this to mean a likely hike at the November meeting.  We remain unconvinced.

Regular readers will be familiar with the 3 elephants in the room.  Before we take our usual canter through UK property it is worth asking ourselves, what has changed with the three elephants in the room?

Elephant update

Global debt levels.  Still rising.  Debt is still rising for consumers and the government.  We think this is the biggest deterrent to interest rates rising.  Our website continually displays the UK and Global debt clocks.


Forthcoming pensions crisis.  Deficits are still rising although we expect this to ease if interest rates and long bond yields start to rise.  The bottom line is that collectively, we are not saving anything like what is required to enable the workforce to retire with a decent pension.

Escalating healthcare costs.  There is huge continuing pressure to provide healthcare to a population gradually getting older.  Demographics in various countries are not favourable.  The recent “Dementia Tax” debacle in the election campaign demonstrates a reluctance by many to recognise this particular issue.  We were interested to observe that the recent issue of Investors Chronicle used an elephant in the room to convey the message that we have been expressing for the last few years.

Pension fund asset allocation 

As pension funds have matured, they have increasingly needed an income to pay pensions.  Property, along with other alternative assets, has been a major beneficiary of this change in asset allocation, but many investment consultants remain concerned about liquidity and valuation issues.  Mature pension funds of stable employers, particularly those pension funds of the UK’s local authorities, should have no concerns about liquidity as the time horizon for such funds is long and for local authorities, it could be regarded as infinite.

As pension funds have matured, they have also become more aware of their liabilities.  To try to bridge the gap between assets and liabilities, pension funds have increasingly bought bonds and moved out of growth assets.  The problem with this approach is that in a low interest rate environment, the income return from these bonds may be insufficient to meet the pension payment obligations without the fund first having to buy substantially more bonds.  As more assets are allocated to bonds to meet income requirements, then the more bond yields contract, further adding to the problem.

Certainly a pension fund can attempt to de-risk in this way but if unexpected inflation comes around the corner, then more funding will be required.

There is no free lunch.  If certainty of pension provision is the goal, then quite simply, more money is needed.  If on the other hand, trustees and investment consultants are happy to endure some volatility and less certainty, then owning some of these alternative assets can make sense.  The yields on offer are certainly much greater than bonds and if inflation does take off, there is some degree of inflation protection.

UK property

Uncertainty caused by the unknown Brexit outcomes is ensuring that businesses are, by and large, postponing expansionary decisions and so delaying signing leases.  We believe that this may continue for at least another year to 18 months and thereafter, there could be a rush to implement these delayed property decisions.

Rents are growing by about 1.8% year on year according to the MSCI Monthly Index, ahead of inflation which is running at just over 1%.

Investors continue to be attracted to property where there is a long lease in place and where the rent is contracted to increase.  Over the longer term (10 years) average rental values have increased by just 0.1% p.a., below the inflation rate over the same period.  With advances in technology and in particular internet related activity affecting both retail and office markets, we see no reason for rents to increase from a supply and demand perspective.  We are therefore committed to our strategy of acquiring assets where there is a quality tenant paying a rent which is contractually committed to increase.  Regular readers will recognise this as RPI Property, the phrase we coined to describe our strategy.


 A brief look at property alternatives

In this ever changing environment investors can be tempted to invest “off-piste” in newer sectors such as care homes. For this particular sector we note that superficially, the demographics are compelling; there will be an increasing number of elderly people requiring such services.  However, increasing regulation and costs (wages and rents) point to probable failure in the years to come.  This has been the experience of several of the larger operators who have had to ask landlords to rebase rents.

One area that may prove more interesting is forestry.  Essentially, the sustainable and long term nature of forestry may be attractive to longer term investors however, the catch here is finding the assets.  Most of the UK’s forests are owned within government control (Forestry Commission) and the market outside of this is pretty thin.  That is not to say that investment funds cannot access this market and over the years we have participated in funds seeking exposure to this sector.

Other alternative assets also include the various PPP and PFI contracts which, if packaged correctly, can provide longer inflation linked income streams suitable for pension fund investors.  Labour have indicated that they would essentially nationalise such contracts and the price investors would receive as part of this exit, is unknown.  Once again, political risk enters this assets class.  It should of course be much cheaper for Government to simply issue index linked bonds to raise the funds to build the underlying hospitals and schools.  The question would then be, can Government manage the contracts to build the schools etc without major cost over-runs?  Recent experience with Crossrail would seem to be positive in terms of ‘on time, on budget’ but we imagine we will have to wait and see before judgement can be made.

Student accommodation was a true alternative when we first invested in the sector some 25 years ago.  Indeed, MSCI Real Estate, then known as IPD, did not have a category for it and simply called it “others”.  Typically, investors were attracted to student accommodation by the long leases available from excellent covenants.  By providing development finance, investors could get a slightly higher yield at day one and moreover, the rents were usually contracted to increase in line with some well-known inflation measure.  For long term investors, this provided the stable long term income they were seeking and so the ‘sheep’ followed.  Now, while the sector is very institutional and in a property sense there is a relatively liquid market, property prices have risen spectacularly.  Risks have also increased, with many covenants now significantly weaker than a traditional university and increasingly looking like hotel operating companies.  The result is that it is not uncommon for specialist management to be required to manage these assets.  Nonetheless, student accommodation demonstrates how early investment into an “alternative” can provide solid returns as the investment type becomes “mainstream”.