Portfolio deconstructed: Swip Property Trust

With global investors increasingly hungry for yield, property is slowly regaining the steady income-providing profile obscured by its 45% peak to trough capital decline from 2007-2009.

“We see little distinction between sectors at present, with performance largely dictated by geography – South East against the rest of the country and prime versus secondary.”

Kerri Hunter

Consensus on the sector is also gradually improving – after another year of capital decline in 2012 – with most groups predicting annualised returns of 7-8% from property in the coming years, with the lion’s share from income. Despite this, many investors are understandably still cautious on the asset class, especially after so many funds were forced to shut down temporarily at the height of the credit crisis as money flooded out. Among the few portfolios not forced to close its doors was the Scottish Widows Investment Partnership (Swip) Property Trust and the fund is continuing to build a solid track record, with income central to returns, as the sector slowly recovers. Swip boasts among the largest commercial real estate investment teams in the UK, running more than £8bn in the asset class. Deputy manager Kerri Hunter – who runs the fund alongside veteran property specialist Gerry Ferguson – says capital values have been falling since last year but are now stabilising, particularly in prime markets. As capital values begin to improve and fundamentals reassert themselves, she is also in the 6-7% annualised returns club, based firmly on property’s steady income profile.This breaks down into a predicted 6.1%pa average return over the next three years and 6.6% over the next five. “From 2005-2007, we had huge yield compression and massive capital gains driving total returns but we are confident most investors now see property back in its traditional solid income-producing role,” she adds. “In tougher markets, keeping and growing that income becomes ever more important, which is where genuine specialists in the space can produce outperformance from this asset class.” Hunter says the market has become increasingly polarised on two fronts, between central London and the rest of the country on one hand and prime and secondary assets on the other. “Macro conditions are still clearly having an impact on occupier markets, with most investors expecting conditions in the broader economy and property space to be further advanced than they are,” she adds. “Our forecasts are made against a background of low growth in the UK, continued economic uncertainty and a recent Budget that does little for overall growth in the short term and nothing for the commercial real estate industry either in the short or long term. “The market is still vulnerable, with businesses cautious and delaying spending decisions, and we basically expect property demand to remain muted until we see sustainable economic recovery. This means a restrained outlook for rental growth and we are not predicting much movement on this front until 2015, 2016 and 2017.”Slow growthWith ongoing reluctance by potential tenants to commit to new space, the group is forecasting market rents to rise by 0.7% annualised to the end of 2015, rising slightly to 1.1%pa over a five-year period. Despite this, Hunter says there are clear pockets of strong rental growth, such as central London offices for example, but this is very much the exception in a sub-sector where rents are under pressure across the regions. London also provides the exception in the general investor focus on prime assets, with the secondary market in the South East performing well and attracting growing interest, particularly as yields on top-quality property are so low. Outside of central London, the gap between prime and secondary assets continues to widen according to Hunter. On the £2.2bn portfolio, the team combines bottom-up property analysis with wider macro and sector calls – although Hunter stresses the former is key as it adds consistent value over the long term. Analysing multi-million pound properties is obviously a very different exercise to researching equities or bonds, with the manager noting risk metrics such as lease expiry profile and strength of covenant. “We will always know our exposure to these across the portfolio so can change one particular source of risk – such as too many short leases – if we deem it necessary,” adds Hunter. “Every property will have its own business plan and our analysis is done on a SWOT basis (strengths, weaknesses, opportunities and threats). In the property space, that involves elements such as location, tenant, and lease length and highlights areas where we can potentially enhance the income stream through actively managing the asset.” All this work enables the team to make comparative judgements on one asset against another and they model total returns out over five years, factoring in purchase price as well as any potential capital expenditure required over the period.Sector differencesWith more than 100 holdings – the average lot size is £15m, ranging from the largest at £80m to several under £1m – the portfolio is well diversified and through focusing on asset and tenant quality, its income risk is lower than the market. At sector level, the Property Trust is largely in line with the IPD index, with Hunter seeing little value in making major shifts between retail, offices and industrials depending on backdrop, particularly given the major transaction costs involved in buying and selling these assets. “In any case, we actually see little distinction between sectors at present, with performance largely dictated by geography – South East against the rest of the country and prime versus secondary,” she adds. “That said, we would obviously highlights issues afflicting the retail space, with consumer spending still fairly depressed and the nature of shopping changing in favour of online. This means many high streets are dying and will struggle to recover so holding the right kind of property in the right towns is vital.” Through focusing on asset quality, Swip has largely avoided the general retail malaise and currently has no vacant high street assets in the portfolio for example. While it has companies such as JJB and Comet as tenants on the retail warehouse side, it was able to re-let these quickly when the businesses went under as the underlying assets are solid. Hunter also notes the ‘other property’ sector as a source of opportunities – where the portfolio has around 10% of assets – with areas such as hospitals and hotels typically offering long leases and built-in inflation protection, both of which are always attractive to institutional investors.DiversificationAs an open-ended direct property fund however, the trust has to hold a certain amount in more liquid assets to deal with flow management. While some peers just sit on cash, Hunter says the 25% outside direct property in the Swip fund also includes equities, bonds and derivatives linked to the sector, offering returns that are at least tied to the overall asset class. They altered the mandate to include this indirect exposure in 2010, introducing another level of diversification and offering better returns than the negligible cash rates currently in place. Since the changes, Hunter says this allocation has been positive for returns, particularly in the fourth quarter of last year. With the backdrop improving, the team also plans to take the 75% direct property exposure up to around 80% by the end of 2013. Looking at some of the holdings in more detail, and outlining how Swip has managed its assets to enhance the income stream, Hunter highlights a property in Guilford previously let to JJB. “This is generally an area with good tenant demand and we were aware of JJB’s problems so took the lease back to get control of the situation,” she adds. “The asset is in an improving location and we have re-let to Metro Bank, which is currently in a massive expansionary phase, and increased the rent by 25%.” Another example is the Hermiston Gait Retail Park in Edinburgh, which the team bought back in 2007 and has subsequently invested a further £3m to reposition and improve the asset. “We were keen to improve the physical appearance first and foremost, generally brightening up the park and making it a more pleasant shopping experience for customers,” adds Hunter. “This has seen the value rise by 20% and we have continued to introduce new tenants, including Decathlon, Currys and an imminent high-end fashion retailer.” Another new tenant is Krispy Kreme – with its first outlet in Scotland – taking more than £60,000 on its first day of trading and causing traffic chaos as motorists queued up to get their hands on the doughnuts.DevelopmentUnlike many peers in the property sector, Swip is also actively involved on the development side as opposed to just buying existing assets. “We bought a site in Hammersmith off market for example and teamed up with Development Securities to transform a former car park into 110,000 square feet of prime office space over eight floors,” adds Hunter. “We are also involved in the re-generation of Sheffield city centre, looking to transform a shopping street into primary assets but redeveloping various blocks on a rolling basis.”