Quarterly Investor Report 31 March 2019

Economy and Strategy

This quarter we delve into the real world of “realpolitik”.  Brexit has, once again, thrown the decision making process of fund managers into sharp focus.  What do you do when there is an imminent event, the result of which is unknown and where the outcome may result in quite different strategies?  The answer, do nothing.

Investment agents, who oil the property market and bring together buyers and sellers, suggest that they are beginning to notice a fall-off in transactional activity.  This is meaningful in a number of ways, not least the valuation of property itself.  When there is an active market, with buyers and sellers of all types (institutional, property companies, private investors and overseas investors) it can be reasonably assumed that whether you are a buyer or seller, you can effect a transaction in a reasonable period of say 3 months.  In today’s market, UK institutions are largely absent despite having reportedly large cash balances waiting to invest.  Overseas investors are worried too, possibly by a lack of certainty over the value of Sterling.  The net result is that the market is dominated by UK property companies and private investors, with the latter only really able to consider investment bids up to the £3 million level.

The Brexit vote on 23rd June 2016 prompted many fund managers to make pricing changes to their funds, despite the fact that to overseas investors,  the UK market and in particular London real estate, was immediately circa 15% cheaper as a result of Sterling’s fall.

In the UK, property investment remains uncertain.  Optimistically, we think that once Brexit is out of the way, business will complete on occupational deals that they have had to place on the back burner.  This could result in a temporary increase in transactions (no matter the Brexit outcome) and inevitably produce some optimism amongst the agency community.

Economic growth over the last 10 years has been modest but positive and realistically, we are due a downward period at some point.  Certainly the 10 year 2 year US Treasury spread has dipped close to nil, often a sign of a recession ahead.

Retail under the microscope

The consumer sector and in real estate terms, the high street and shopping centres, has been at the forefront of change over the last few years with many factors involved including:

  1. The rapid growth of online shopping across all sectors
  2. High local government taxes through the rating regime
  3. High rents
  4. Low economic growth
  5. An increase in the use of Company Voluntary Arrangements (CVA’s)
  6. Tenants taking shorter leases and ‘downward’ rent reviews

We believe that of the above, the growth of online shopping has had by far the biggest impact and the end position has not yet been reached.  The UK, being a relatively populous island, with an established delivery service (dominated by the Royal Mail), has been a great place to trial virtual high street models supported by efficient delivery methods.

The online genie is well and truly out of the bottle and whilst there are a range of views on the ‘benefits’ of online shopping against the loss to traditional high street shops and the hollowing out of many town centres, the result appears to have been a net benefit to many consumers.  This net benefit is represented through cheaper goods, accessed more conveniently.

At the massive warehouses which provide distribution nodes for many of these online businesses, the employees may see their jobs commoditised and so become vulnerable to hourly employment contracts, reduced collective bargaining power and a reduction in benefits.  The fact that many of these online behemoths apparently pay little or no tax relative to their turnover and profitability levels and when compared to the tax burden falling on their high street competition, is leaving them as an open goal to political activists wishing to see change.  As a result we do expect some levelling of the playing field from Government as time goes on.

While online shopping has benefits to consumers as outlined above, these benefits appear to be at considerable cost to landlords (many of whom are pension funds of the consumer), at a cost to employees through poorer working conditions and at a cost to local authorities as vacancies increase and local tax receipts fall.  Add to that the social impact of vacancies of many local high streets and the overall benefit becomes questionable.

With growing financial pressures, many tenants are turning to Company Voluntary Arrangements in an attempt to salvage some of their business.  As well as the numerable CVA’s and company restructuring that we have witnessed recently, Sports Direct have been very active buyers of retail assets.  Often, Sports Direct’s immediate strategy involves renegotiation of rents and shutting unprofitable stores so the net position is more pressure on the landlord and more empty stores on the market.  Other successful retailers include Next who are managing their retail portfolio on a much longer and transparent basis than we have witnessed others doing.

While the high street tries to cope with these issues, the Trust takes a cautious view on the retail sector.   The exception to this is convenience supermarkets which appear to be bucking the trend.  While the reduction in the big weekly or monthly shop for groceries may be adversely affecting the large supermarkets, both online grocery shopping and more frequent smaller purchases of essentials from convenience supermarkets has presented a balance.  As a result, we have favoured convenience stores as an investment opportunity.  Many of these investments include our desired objective of representing a natural home to the tenant or type of tenant.

 Natural Home – what does it mean?

We are often asked about our evolving strategy of buying assets where the property is viewed as the ‘natural home’.  So what does this mean?  In a nutshell, we usually explain this by stating that we are looking to buy an asset where the tenant (or type of tenant) has a reason to be there other than the contractual lease.  Some would state that every property can be described in this way and so we are prompted further to clarify.

Natural home can include situations where the tenant is an adjacent owner or occupier and having joint premises adds to their business model in a 2+2=5 fashion.

Equally, the small supermarket Keills Property Trust owns in Dundee has had a supermarket on site for over 40 years and we expect the local population will need a convenience the food offering for the foreseeable future.  The main residential neighbourhood is tenement flats and many shoppers are students who refill their rucksacks on a regular basis.

Other examples of natural home would be a hub of specialist occupiers, a hotel anchored by an immovable tourist or business landmark, a distribution shed on an intersection of major road networks.  These are just a flavour of some of the characteristics of properties which would qualify under the natural home selection criteria.

We look for businesses which are themselves sustainable and will be around for the foreseeable future.  We adopted the natural home philosophy in 2011 and have applied this to all the properties acquired since then and is applied to 6 out of the 7 properties currently owned.