August 2011

By | 15th September 2011

A torrid month for equities globally and pan-European real estate shares were no exception with the Fund’s benchmark falling 7.2% (total return, GBP). In rapid ‘risk-off’ periods and heightened volatility, correlation across asset classes increases. Whilst I wrote last month that the longstanding (strong) correlation with the broader financials group had broken earlier in the year, the relationship did reassert itself in August, but not as robustly as in previous years. The BBG European Financials Index was down 15% over the month, significantly underperforming real estate shares.
We believe this is important. The underlying assets in the sector are leveraged but this is not a repeat of 2007/8 for three critical reasons (1) asset pricing is still 15-30% below the peaks of Spring ’07 (2) balance sheet rebuilding / fresh equity has resulted in Loan-to-Value averaging around 40% – much more stable and (3) earnings are robust with companies able to take advantage of very low short term rates. In fact – a number of businesses we invest in have announced that they are swapping out floating rate debt for fixed as the terms are too good to miss.

Whilst the Fund had external gearing of 8% at the end of July, it also had 10% of its assets in unleveraged physical property. This meant we entered the month effectively with no external leverage against the equity portfolio. The relative underperformance was a result of our bottom-up fundamental approach, which highlighted the relative overvaluation of both Swiss and Belgium property companies. In the former, we were well aware of the ‘safe haven’ credentials of Swiss companies but earnings yields of sub 4% and vacancy rates of 10% in the Zurich office markets were not attractive. It is worth noting that the Fund does not take currency risk (versus the benchmark) and whilst we held underweight positions in the stocks, we held benchmark equivalent currency exposure (in cash or forwards). The Swiss companies (in CHF) fell just 0.4% in the month. Now standing at double-digit premiums to asset value (versus a sector average discount of – 15%) we believe that such relative outperformance will not be repeated and maintain our position.

Earlier in the year, the Fund made a tactical decision to increase its physical property exposure and this month it acquired an office building in Vauxhall, investing £8.25m. The property is multi-let and yields 6.75% net. We intend to carry out a number of asset management initiatives in the next 12 months.

As I said at the AGM (late July) we expect these bouts of volatility to continue and the Fund will maintain its strategy of seeking exposure to quality assets and management in markets where we see the correct rental growth dynamics.

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