Real estate was the worst performing GICS sector in September. Inflation data continues to print higher figures, encouraging central banks to react more hawkishly as they seek to control the demand-driven inflationary stimulus. Unfortunately, that control mechanism has little impact on energy costs, which are one of the key drivers of this inflationary surge. Over the course of the month, investors became increasingly concerned about the trajectory of base rates and the impact on funding costs. Moreover, politics also played a part in investor worries, with the well-documented fiasco of the UK government’s ‘mini-budget’. At the beginning of the month, markets were pricing a peak base rate in the UK of around 4%. This shot up to 6% in the aftermath of the politically driven uncertainty. The negative impact on sterling makes matters worse. The UK imports a lot more than it exports, and devaluation pushes up import prices. The sterling devaluation may also increase the persistence of inflation once the peak has passed.
The UK will not be the only country to experience the difficult mix of simultaneous fiscal latitude (by governments) and hawkish responses from independent central banks.
Once again, it was the most indebted companies that suffered the most. Swedish property companies collectively fell -19% (in Swedish krona). The UK was not far behind at -17.5%, with the steepest share-price corrections from the largest and lowest-yielding (highest-valued) companies, such as SEGRO (-20%), Landsec (-19.8%) and British Land (-18.6%). This was not a stock-picker’s month and everything felt like it had a beta of 1. The quality and longevity of the tenant roster seemed to count for nought in the rush for the exit. We continue to focus on businesses with strong tenants who want/need their buildings, and where the debt on each balance sheet is not only a manageable quantum but has little or no near-term refinancing. The aim is to focus on businesses where earnings will not be degraded by rising debt risk but will have the opportunity to grow through indexation or market-driven rental growth. We continue to avoid consumer-facing property where the spend is discretionary; we think tenant demand will weaken. This will be felt most acutely in countries with high levels of home ownership (e.g. the UK, Spain and Poland) where mortgage resets will materially impact net disposable incomes.
Residential owners also performed poorly. While the rental income (particularly from regulated rents) is secure, the ability to capture indexation is muted by the partial recovery of energy costs. The larger German companies, such as Vonovia (-17.8%) and LEG (-18.5%), saw sharp corrections, while our only significant overweight company, Phoenix Spree (4% of assets), fell just -3% over the month. The larger companies are not only trading at 30% discounts to their last-published asset values but also at +50% discounts to the cost of rebuilding their estates. With such valuations, significant levels of new construction are not viable, even as inward migration and the growth in the number of households provide steady demand. We remain confident on the sustainability of earnings from these businesses.
Our major sector overweight remains logistics and industrial where we see structural demand tailwinds from re-engineered supply chains as well as ongoing evolution of the omnichannel retail environment. The elevated levels of anticipated rental growth had driven initial yields to record lows, and the correction in the risk-free rate resulted in dramatic capital-value movements. We firmly believe that rental growth and development gains will remain a feature of this asset class.
In September, the net asset value (NAV) fell -15.9% while the benchmark was down -15.3%. The share price saw the discount widen slightly, leading to a correction of 18%. The NAV movement included the six-monthly revaluation of the property portfolio, which saw a like-for-like decline of -7.5%. During the period, we sold the remaining residential interest in The Colonnades in Bayswater for £5.05m. The physical portfolio now comprises 8.5% of net assets.
Discrete rolling annual performance as at 31.10.2023 (%):
Performance data is in GBP £ terms. Investors should be aware that past performance should not be considered a guide to future performance. All fund performance data is net of all fees and expenses.