Threadneedle UK Property Fund II - Threadneedle Investments

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Threadneedle UK Property Fund II Interim Report and Accounts 2012 Manager’s Report Investment Objective The investment objective of the Company is to achieve longterm capital growth and income primarily through direct investment in, or exposure to, UK commercial property. Investment Policy The investment policy of the Company is to invest in UK commercial properties (including shops, offices, retail warehouses, leisure and industrial units), as favourable investment opportunities arise. The Company may also invest in property related securities, regulated and unregulated collective investment schemes, debt instruments and other transferable securities to gain exposure to the UK and other property markets. In addition, the Company may invest in money market instruments, deposits and cash and near cash. Review This report covers the period from 1st January 2012 to 30th June 2012. Market Commentary 2011 saw no let-up in the tough economic back drop for business right across the UK, with significantly sub trend economic growth during the year of just 0.7%. Fluctuating degrees of uncertainty around the Eurozone have been and continue to be, a significant drag on the UK economy. The prospect of a breakup of the Eurozone is holding back business investment by cash rich corporates making credit difficult to obtain, limiting the export market for UK manufactured goods and negatively effecting overall sentiment. Unemployment has risen to 8.3%, its highest level since the early 1990’s. The UK economy recorded negative GDP growth in the final quarter of 2011, and the first quarter of 2012, meaning technically the UK has entered recession again. This economic environment, coupled with the UK Government’s on-going policies aimed at tackling public sector debt have inevitably continued to temper both business expansion and consumer expenditure and therefore occupational demand. Whilst masking some regional and sector variances, occupation markets over the past year have generally been alive and functioning but not buoyant. Market wide rental value growth for the twelve months to the end of June 2012 has been 0.0%. Overall vacancy rates have also been broadly stable (the source of all market statistics in this section being the IPD UK Monthly Index). The one material exception to this general synopsis of occupational markets is the Central London office market. Modest supply, particularly in the West End, and a greater willingness amongst businesses to commit to new accommodation, has generated positive rental value growth in the central London office market of around 5%. A particularly positive feature of the commercial property sector over the past three years has been the generally robust nature of portfolio wide rental income flows. It has been estimated that from its peak in September 2008 to January 2012 the aggregate rental income generated by the portfolio that makes up the IPD UK monthly index fell by just 2.2% (source: CBRE). This highlights one of the key positive characteristics of UK Real Estate as an asset class. When compared to alternative asset class pricing, such as UK equities and Gilts, UK commercial property remains an attractive proposition and is considered to present fair value. Continued concerns over the Eurozone debt crisis, the impact of spending cuts in parts of the public sector and a lack of available debt, have combined to have a negative impact on the market and 2012 is set to continue in a similar vein to 2011. From an investor’s perspective, the twelve months to the end of June 2012 was a presentable period for the real estate sector, particularly when compared against the volatility across other investment sectors. Total returns over the period for the UK commercial property market were 4.8%, ahead of the negative 3.1% total return from UK equities, but behind the 16.1% total return achieved by the prolonged bull run in gilt markets. This property sector out-turn was entirely down to the sectors rental income return of 6.7%, with capital growth being negative at –1.9%. During the last eight months of this period, property investment yields have displayed a slight softening following a twenty-seven month period of month-on-month positive yield impacts. This is consistent with the unfavourable trend in the balance between active buyers and sellers in the UK property investment market, reflecting a back drop of less equity flowing into the market and an on-going desire amongst banks to decrease their real estate exposure. Although UK property fund inflows are currently at negligible levels, it is reported that, after record inflows in the period 3Q09-4Q10, institutional investors still hold significant un-invested cash balances, but remain wedded to a cautious investment approach. Institutional investors seeking to exploit the property sector’s income yield advantage, relative to competing investment media, remain focussed upon the acquisition of core/core+ property assets, long-let to undoubted tenant covenants. Institutional investors currently have little appetite for entrepreneurial property risk. It is widely considered that, whilst values remain subdued outside of Central London, those investors with significant cash weightings continue to be in a privileged position to take advantage of comparatively low pricing on assets with robust underlying fundamentals. UK Property Market Performance – 12 Months to 30th June 2012 All Retail Office Industrial Property Total Return 3.0% 6.4% 5.9% 4.8% Income Return 6.5% 6.6% 7.7% 6.7% Capital Growth -3.3% -0.2% -1.7% -1.9% Rental Value Growth -1.1% 1.6% -0.8% -0.1% Yield Impact -2.1% -0.5% -0.9% -1.3% Source: IPD UK Monthly Index June 2012 3
Threadneedle UK Property Fund II Interim Report and Accounts 2012 Manager’s Report (continued) As displayed in the table above, it was the office sector that generated the strongest total returns over the period, registering 6.4% and being the only sector with positive rental value movement. This was however very much a product of the relatively strong performance of the Central London submarket which produced total returns of 10.4%. The retail and industrial sectors both suffered negative rental value growth of –1.1% and –0.8% respectively, although the industrial sector’s higher income return resulted in it generating a total return of 5.9% compared to that of the retail sector of 3.0%. Market Outlook With GDP growth of 0.3% forecast, output levels in 2012 are predicted to be low. Such low growth and output will undoubtedly hold back expansion in the occupier markets, which, coupled with a lack of available debt, will also act to limit activity levels in the investment markets. The issue of forced disposals through legacy debt issues will also be prominent, as the UK banks look to further deleverage balance sheet exposure. Banks still have more than £210bn exposure to UK commercial property, with nearly a quarter of loans in breach of terms or default. More than half the debt has to be repaid by 2016 with approximately £50bn due to mature this year. With only modest inflows into UK pooled property funds and a dearth of debt finance to take its place, it has been no surprise that recent months have seen small incremental falls in property capital values across the market. Perceived volatility in the financial and economic environment, particularly centred around the Euro crisis, has not helped risk aversion amongst investors. We expect these dynamics to be an on-going feature of 2012, with investors in property benefiting from the sector’s solid income return but seeing this eaten into by modest negative capital value movements. Beyond this immediate outlook we remain of the view that prevailing property pricing does look logical and supportable over the longer term perspective, a time horizon that property investment, by its nature, demands. An eventual return to trend economic growth in the UK does present real upside for UK property markets, the majority of which have experienced a de minimus level of fresh construction activity for nearly half a decade. The Company is now experiencing a period of stability following a pronounced expansionary phase. Although UK property fund inflows are currently at negligible levels, it is reported that, after record inflows in the period 3Q09-4Q10, institutional investors still hold significant un-invested cash balances, but remain wedded to a cautious investment approach. Institutional investors seeking to exploit the property sector’s income yield advantage, relative to competing investment media, remain focussed upon the acquisition of core/core+ property assets, long-let to undoubted tenant covenants. Institutional investors currently have little appetite for entrepreneurial property risk. The Portfolio The average weighted lease length across the entire portfolio of 12 properties and 14 tenancies is approximately 5 years, assuming all lease break options within the existing portfolio are exercised. The Company’s directly held property generates a combined net initial income yield of 6.4% a 10 basis point income yield advantage above the comparable (IPD Monthly Index) market yield. We have shown a sector breakdown of the portfolio below, which shows the Company’s position versus the IPD UK Monthly Index. Sector breakdown – as at 30th June 2012 Company Index Active Retail Warehouses 18% 24% –6% Shops 47% 23% 24% Industrials 21% 17% 4% Offices 14% 31% –17% Other – 5% –5% Property Type Overview 47% Source: Threadneedle We have shown a sector breakdown of the portfolio below, illustrating the Company’s position versus the IPD UK Monthly Index. Sector Breakdown as at 30th June 2012 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Company Index Offices Shops Industrials Retail Other Warehouses Source: Threadneedle/IPD 14% 18% 21% Offices Industrials Retail Warehouses Shops Other Income returns will form the core component of total returns over the next 5 years and capital value gain will have to be 4
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