Quarterly Investor Report 30 September 2019
Economy and Strategy
Another Brexit deadline looms. For three years we have watched from the sidelines and have been trying to work out what this means for our economy, our investors and ourselves. We may not have much longer to wait and we feel that the outcome is gradually moving towards a hard Brexit. Ultimately， this will be a political decision based not particularly on choice, but because there was not a strong enough or cohesive enough group who were going to oppose it.
Following Brexit, there is an expectation of a General Election and a likely Conservative majority Government. How long this new Government stays in place depends a great deal on the severity of Brexit itself and how any necessary mitigation is implemented. An important factor will be the level of ‘relief’ felt that at last a decision has been made and business and the public alike can move on. This sense of closure is likely to boost GDP for say six months as investment and operational decisions, which had been put on ice, are now at long last implemented.
The Global economy has made a definite pause, not surprising after so many years of even modest growth. The US was expected to raise its interest rate on 3 occasions in 2019 however there has actually been a cut, with the next movement now expected to be downward.
The European Central Bank currently led by Mario Draghi has begun another phase of QE, buying €20 billion of bonds monthly. It will be interesting to see if Christine Lagrange will wish to continue this policy. Recently, some economists have described QE as a placebo for the patient. The patient is ill and wants something to ease the pain, but Central Banks have run out of proper remedies and therefore are buying bonds knowing while it is likely that little will happen, the patient may actually feel a little better.
In the UK, 10 year bond yields are now circa 0.60%, hardly offering a return to investors at all and this is widely used as a benchmark or ‘risk free’ rate looking forward for the next 10 years. We suspect that capital allocation decisions made on the basis of these low yields will be proven wrong.
Let’s roll various assumptions forward and analyse the results.
|Yield Sept 2019||Yield Sept 229||Expected total return|
In the above, we are only concentrating on UK Sterling assets and we have made further general and modest assumptions regarding rental and dividend growth. While all we have done is simply to roughly double the start yield from bonds, the standout is the appalling returns they produce over the next 10 years. Given the above, a strategy heavy to bonds only really makes sense if deflation kicks in aggressively. In that case, bond yields would not rise so much and a low, nominal yield may look more attractive in real terms. The question is, how likely is it that this general deflation will be present in UK, and Europe?
Brexit in the UK is pivotal to any outcome and clearly there a distance yet to travel, but our gut instinct, even given recent glimmers of positivity coming from London and Dublin, is for a hard Brexit on Oct 31st with the alternative being, a hard Brexit after a Tory win at a General Election.
Transaction activity is slowing and occupiers, as well as investors, are taking stock which is not really too surprising at the current time. WeWork, the provider of office space and who, by taking space in many new developments in return for long rent free periods, have been dominating the Central London office market, are now pausing their growth. As a result, landlords who have WeWork as a tenant are thinking again about the quality of this tenant and whether rents will be paid when rent free periods expire. The cancelling of WeWork’s IPO had an immediate effect on headline rents.
The WeWork model is not proven in a down turn, with their tenant clients usually requiring flexible occupational leases whilst WeWork themselves, have often 20 or 25 year lease commitments. If the market weakens, we can expect vacancies to rise at WeWork buildings which may make their own rental commitments difficult to honour. The same happened in the early 1990’s with Regus before it became part of IWG plc. Then, there was nearly carnage however, the flexibility in leases offered by Regus meant that their offer was attractive to occupiers and they have survived and prospered. WeWork may be in for the same growing pains.
There are still casualties in the retail sector with many struggling to adapt to the lower footfall environment. One winner, which we have overlooked, is the privately held Selfridges which has been able to continue to grow customer numbers and vary the offer to shoppers. Their Oxford Street London branch (they have 4 branches) has a skateboarding bowl where you can learn to skateboard with professional tuition. This is part of a 3 year, store investment programme of £300million which appears to be well targeted and profitable.
Big Box warehousing also seems to work with Tritax Big Box continuing its expansion by developing close relationships with end users to bring investors long leases often where the rents are geared to the Retail Prices Index.
Uncertainty and investment go hand in hand. If returns were guaranteed, then returns from property would dive down to the returns expected from bonds. Every bond (in an offering) is identical and this is where property and bonds differ. Our current deal flow suggests there are ample opportunities to get a much higher return from property than bonds, without a corresponding ramp up in risk. The investment strategy of Keills Property Trust aims to exploit these opportunities.