Commercial Property

UK real estate recorded a period of greater stability in the first half of 2023 following the significant repricing the sector experienced in late 2022. That repricing was principally driven by increased interest rates raising the cost of debt in what was a largely a debt-driven property market, while rising gilt yields reduced the yield margin available from property versus the risk-free rate. These sudden movements also dented investor conviction on asset pricing. Although this has served to help insulate UK real estate from economic volatility during the first six months of 2023, market volatility and macro headwinds continue to impact investor sentiment, which has remained weak. Underneath the bonnet of real estate, occupational strength endures in many sectors and, indeed, modest capital value growth has been recorded in those sectors that benefit from structural tailwinds, such as industrial and logistics.

According to the MSCI Balanced Portfolios Quarterly Property Index, all property recorded a total return of 0.0% over the first half of the year with capital values falling by 2.3%. However, this hides sector variance with the industrial sector recording capital growth of 0.3%. Office values remain under pressure and saw capital value declines of 6.7%.

Transaction volumes have also remained constrained during the first half of 2023 as investors have taken a risk off approach. According to Real Capital Analytics data, approximately £18.3bn transacted across the UK to June 2023. To put these number volumes in perspective, this is lower than the same period in 2020 during the onset of the Covid-19 pandemic and 37% below the 10-year H1 average. Proportionately, each of the three principal sectors – industrial, office and retail – accounted for broadly similar volumes representing between 20-26% each.

Interestingly, transactions in residential assets continue to rise, with the sector accounting for 19% of total half year volume. Transaction volumes are anticipated to remain subdued over the remainder of the year against a weak macroeconomic backdrop and volatile interest rates, with owners of good quality real estate likely to remain unwilling sellers. Improved investment activity is likely to be prompted by greater confidence around the path of the Bank of England’s monetary policy, with an end to base rate rises likely to improve investor sentiment.

Improved sentiment returned to the industrial and logistics sector during the second quarter of 2023, with pricing and performance demonstrating tentative signs of stabilisation. Whilst short-term pressure, as a result of the weaker macroeconomic environment and rising debt costs, is expected to affect investor confidence, the sector continues to benefit from significant structural and thematic tailwinds. We now expect continued longer term positive performance, which will be driven principally by robust rental growth. Supporting this, and despite an increase since the start of the year, UK industrial vacancy remains near historic lows, with any new supply unlikely to satisfy current occupational demand.

The office sector remains under structural pressure as evolving working habits and economic uncertainty impact occupancy. In London, supply levels are rising and, according to Deloitte, over 10 million sq ft of new accommodation is expected to be completed this year, which is the highest level in over 20 years. Rising supply and weakening demand are forcing the vacancy rate higher, with the Central London vacancy rate now more than 9% according to CoStar data; the bulk of which relates to old stock as occupiers increasingly seek prime modern space with strong environmental credentials.

We expect this to dampen rental growth prospects and expediate the bifurcation in performance between new and old. Investor demand for UK offices remains weak amid a poor outlook for the sector. Further capital value declines, particularly for secondary office assets, are expected.

The retail sector has proven to be more resilient than many had expected over the first half of 2023. According to the Office for National Statistics (ONS), retail sales in the UK unexpectedly expanded in May, boosted by spending on summer clothing and outdoor goods. While the presence of discount retailers in the UK is not new, changes in consumer shopping behaviour have propelled them to the top of the wish list for many UK retail schemes. Discount retailers have been a key beneficiary of a more cost-conscious UK consumer illustrated by B&M’s recent results, reporting like-for-like sales growth of 9.2% in its UK business over the first quarter of 2023. As a result, retail parks with a strong discount-orientated line-up remain in high demand for UK institutional investors.

Investor sentiment towards the purpose-built student accommodation (PBSA) sector remains positive and underlying occupational demand is robust, as illustrated by strong booking momentum for the 2023/2024 academic year. Like build-to-rent residential, there is an acute shortage of supply, particularly for the strongest university towns, which supports rental value growth for the sector. Investment volumes are down over 80% year-on-year for the sector. However, this is primarily due to a limited amount of investment stock being brought to the market, as opposed to any softening in investor sentiment towards the sector.

Portfolio Performance

Following the sharp macro-led valuation correction experienced in the second half of 2022, it is good to see UKCM’s portfolio valuations stabilising and growing in the first half of 2023. The portfolio delivered a total return of 3.9% over the first six months, significantly ahead of its MSCI benchmark that was flat at 0.0%.

The table below breaks down this return by sector with all valuations undertaken by the Company’s external valuer, CBRE. The portfolio delivered an income return that is marginally ahead of benchmark (2.3%) at 2.4% over the year to 30 June. However, UKCM recorded significantly higher capital growth at 1.5% while the benchmark saw capital decline at -2.3%. The Company’s tactical overweight position to the strongest performing sectors of industrial and retail (retail warehousing and supermarkets) helped drive returns, as did the portfolio’s strategic underweight position to the weakest returning sector of offices which is facing structural headwinds.

Source: MSCI June 2023

Industrial

The Company has maintained a strategic long term overweight position to the industrial sector, which continues to be well placed to benefit from the structural drivers that have fuelled the occupational market. Although it is widely accepted that tenant demand has tapered off slightly from its peak in 2020 and 2021, it remains healthy and significantly outstrips supply in key locations, which is reflected in robust rental levels. Key markets are likely to face an undersupply of stock moving forward as development remains constrained due to a combination of elevated build costs, weakened yields and high finance costs. Investor interest remains strong in the sector, although debt-backed buyers often have strict running yield targets they are required to meet to cover finance costs, which means a return to very low yields of 2021 / early 2022 is unlikely.

In the first half of 2023, the Company’s industrial holdings delivered a strong total return of 6.7%, well ahead of the benchmark level of 2.5%. This was due to significantly stronger capital returns of 4.7% against the benchmark return of 0.3%, whilst the industrial portfolio income return was marginally below benchmark (2.2%) at 1.9%.

Overall, industrials remain the strongest performing sector in the benchmark and the Company’s 58% exposure (benchmark 34%) enhanced overall portfolio returns. Portfolio industrial holdings are split respectively between multi-let industrial estates at 48% by capital value and 52% by capital value in single-let big-box distribution units in strategic locations throughout the South East and the Midlands. In general, the multi-let estates offer more immediate prospects for asset management and therefore opportunities to grow income, whilst the distribution units tend to be longer let and offer secure income streams with the opportunity to capture growth at rent reviews and lease renewals. We expect returns to be driven principally by rental growth going forward and UKCM’s key focus is on capturing reversion within the industrial portfolio.

Office

The Company has a deliberately low exposure to the office sector in absolute and relative terms at 13% against the benchmark weighting of 26%. The sector faces structural change with long-term tenant demand levels an unknown as post-Covid-19 working patterns continue to evolve, whilst landlords face an increased cost burden to comply with future ESG legislation. Overall, we see tenant demand for office space reducing and focusing on the very best buildings that can offer high levels of amenity, wellness facilities and strong ESG credentials. These requirements mean landlords face increased costs against the current backdrop of economic instability, which traditionally restricts tenant demand for office space. This has led to a reduction in investor demand, with the market polarising between a select number of investors targeting the very best high-specification offices and those targeting riskier assets with repositioning potential or high yields.

In this context, the Portfolio’s office assets delivered a negative total return of -3.2%, which was ahead of the benchmark level of -4.9%. UKCM’s offices delivered an above-benchmark income return of 3.3% (benchmark 2.0%) and saw a slightly less pronounced capital decline of -6.3% (benchmark -6.7%). The Company is deliberately underweight to lower yielding London offices, with the vast majority of its office exposure being elsewhere in the South East or in regional cities where yields are generally higher. The Company’s office assets are frequently reviewed to ensure they remain fit for purpose and can meet the needs of current and future occupational trends, including appropriate ESG requirements.

Retail Warehouse/Supermarkets

At the half year, the Company’s weighting to retail was 15% compared to 23% in the benchmark. The retail portfolio only comprises supermarkets and retail parks dominated by either bulky goods retailers or convenience and discount operators. These tenants have proven to be resilient in challenging economic circumstances where spending is likely to be focused away from non-discretionary items and therefore supermarkets and retail warehousing remain sectors favoured by investors. All UKCM’s retail parks are fully occupied. The Company has no exposure to shopping centres and its only high street shop exposure is a minority element within its well-located office investment at 81 George Street in Edinburgh.

The quality of the Company’s retail portfolio is demonstrated by its performance against benchmark, delivering a total return in the period of 5.7% against 2.0% recorded by the benchmark. This was principally driven by much stronger capital growth in the period of 2.8% against -0.9% for the benchmark, with much of this performance derived from the retail park element of the portfolio.

Alternatives – Leisure/Hotel/Student Accommodation

Within the alternatives sector we saw a negative total return of -2.6% in the first half of 2023, while the benchmark was broadly flat at -0.1%. Underperformance was driven by a greater capital decline in the portfolio of -5.7% against the benchmark of -2.4%.

At the end of the period, alternatives comprised 14% of the Company’s portfolio value (benchmark 18%) and was split between three cinema-led leisure schemes in Kingston-upon-Thames, Glasgow, and Swindon and four hotel / student housing assets; one of which is a development that will not fully contribute to portfolio performance until completion in Q3 2024. Capital decline was driven by the leisure schemes in Glasgow and Swindon where Cineworld is a tenant. The Company successfully renegotiated two leases with Cineworld following its Chapter 11 process in the US and importantly retained them at the two assets. The leases were varied to reduce the tenant’s outgoings and to ensure the tenant can operate profitably going forward. This led to a capital decline at the assets and the reduction in rent represents c.1% of the annualised portfolio rent as at 30 June 2023. Despite this adjustment the annualised portfolio rent roll, on a like-for-like basis, remains higher than at the start of the year.

Investment Activity

Within the period the Company sold its 186,455 sq ft Wembley 180 logistics asset in London to Covent Garden IP Limited, a registered charitable company at a strong price of £74 million, which reflects a net initial yield of 3.49%. The sale was broadly in line with the asset’s latest valuation. UKCM had owned the property since 2009 and had completed its business plan having undertaken a comprehensive refurbishment of the property in 2019 when it let the unit to a global e-commerce company until 2029.

The asset was identified for sale given its low initial yield and its rent review structure, which is linked to CPI inflation with an annual cap and collar of 1.5% to 3%. This meant it was not possible to access the property’s full underlying rental value until lease expiry in 2029.

Covent Garden IP Limited was identified as one of a select number of motivated buyers able to take a long-term view on the income profile, given the asset has very limited short-term asset management opportunities. In addition to crystalising a strong return of 15% per annum over UKCM’s period of ownership, the sale provided an opportunity to optimise the Company’s balance sheet, with the proceeds used to enhance earnings by paying down a substantial amount of the Company’s Revolving Credit Facility (RCF). This was reduced by 71% from £93 million at end December 2022 to £27 million at end June 2023.

Asset Management and Rent Collection

Following the trend seen throughout 2022, rent collection rates have remained strong within the portfolio in the first half of the year and are maintained at pre-pandemic levels. There continues to be some tenants within the portfolio that pay rents, by agreement, on a monthly, as opposed to quarterly, basis. Allowing for this, collection of rent due for the three billing periods of this year stands at 99%.

The Company benefits from low tenant income concentration due to its diverse tenant mix of 193 tenancies across 39 assets, with its top tenant, Ocado, accounting for 6% of contracted rental income and the portfolio’s top ten tenants according for 34%.

The portfolio has a high occupancy level of 95.6% at the end of H1 2023 which reflects a void rate well below the MSCI Benchmark rate of 8.1% at the end of the same period. Portfolio vacancy has increased slightly over the year, primarily driven by the completion of two speculative industrial units at Sussex Junction in Bolney, and Precision Park in Leamington Spa. Both are high quality properties with excellent ESG credentials. Sussex Junction is now fully let from August 2023 with the speculative unit leased to Birch Sussex Ltd, an asset storage and concierge business, leasing the c. 47,000 sq ft Unit 1, on a 15-year lease without break. This has increased the rental rate of the property to £14.50 per sq ft, delivering annual rental income of c. £677,000. The agreement commences with two years at half rent and five-yearly open market rent reviews. Precision Park in Leamington Spa is attracting good level of tenant interest.

Almost half the Company’s remaining vacant properties comprise new or newly refurbished industrial assets and we have a high degree of conviction in announcing further strong lettings in the near term.

Asset management highlights within the period included:

Development

UKCM has made excellent progress on its development programme throughout the period, achieving completion of three assets which are now fully integrated with the portfolio. There is only one ongoing development project, the 305-bedroom Hyatt hotel in Leeds, which is detailed below.

Practical completion of the 107,00 sq ft industrial development, Sussex Junction, in Bolney was achieved in Q1. The high-quality development, which occupies a strategic location south of London, comprises three units. Two units were pre-let to geological services company CGG on a 15-year lease at an annual rent of £780,875 pa and the third unit of 46,500 sq ft was let after the period end, in August, to Birch Sussex Ltd. The development is rated BREEAM ‘Very Good’ and has an EPC rating of A for its shell and core.

The Company’s 226-room student housing development at Glenthorne Road in Exeter also completed during Q1. The asset is let directly to students and UKCM benefits from guaranteed Year 1 income of £1,650,000.

There is already strong momentum for the 2023/2024 academic year with over 90% of available rooms let. The development has an EPC B rating, benefits from PV solar panels on the roof and is targeting a BREEAM ‘Very Good’ rating.

Most recently, the development of Units G&H at Precision Park in Leamington Spa was successfully completed. The flexible building provides 67,700 sq ft of high-quality industrial space with the option to sub-divide to accommodate smaller requirements. The units have strong ESG credentials with an EPC rating of A and a BREEAM ‘Very Good’ rating, as well as PV enablement. The completed asset is attracting encouraging levels of occupier interest.

Construction continues at the Company’s Hyatt-branded 305-bed hotel development at Sovereign Square in Leeds. The hotel remains on target to open in Q3 2024 and construction has reached the twelfth and final floor. The top floor will offer a bar and restaurant with views over Leeds and the surrounding area. The hotel will be operated under the Hyatt brand by leading hospitality company Aimbridge who have taken a lease over the premises.

UKCM’s rental income will be solely derived from the performance of the hotel, which we are confident will be strong given its prime location, high specification and the quality of the operator. The remaining development spend will be funded via UKCM’s RCF, the cost of which is effectively offset from a finance return of 6% on expenditure throughout the construction period, and deducted from the final payment to the developer. UKCM forecasts an attractive 7.25% yield once the hotel completes and stabilises.

Environmental, Social and Governance (ESG)

The Company has again submitted its portfolio information to GRESB and preliminary results show that it has been awarded three stars, in line with its previous year’s award. The Company has also obtained a Gold rating from EPRA for ESG reporting in 2022. UKCM continues to track its progress towards its long-term goals of Net Zero Carbon for landlord emissions by 2030 and Net Zero Carbon for all emissions by 2040.

ESG Case Study

The Company takes its ESG responsibilities seriously and seeks the positive implementation of its values across the portfolio. Its student housing developments provide an excellent opportunity to positively contribute to society and the welfare of its student residents is paramount.

UKCM has retained leading student housing operator Homes For Students to manage Hill View Place, its newly developed 226-room property in Exeter. In its opening year the asset has welcomed 140 students from 25 countries. Ensuring the students feel safe, comfortable and engaged at the property is a key focus for UKCM and Homes For Students.

A total of 60 student events were organised throughout the year to help foster community spirit within the property, ranging from ‘meet and greet’ events, quizzes, movie nights, baking competitions and cultural celebrations including Chinese New Year festivities. There are also several environmentally focused initiatives at the property covering recycling, energy efficiency and raising environmental awareness.

Fact

2.1 tonnes of waste has been recycled from November 2022 to June 2023 at Hill View Place, which is equivalent to the total weight of 20 baby elephants!

Student wellbeing is a key focus for the property team, which worked with Student Minds, a charity that empowers students to prioritise their mental health, and the University of Exeter to ensure students are supported, particularly during challenging times of the year such as exam periods. Throughout the year students are invited to chat with staff if they have questions regarding the accommodation, academic life, or just simply wish to talk to somebody.

Fact

Hill View Place is rated No.1 in Exeter on student housing review site Student Crowd with a rating of 4.85/5.

The combination of the excellent quality of the accommodation itself, alongside the care and focus of the Company’s operator in creating a healthy environment for the students, has led to extremely positive feedback from residents. Hill View Place is currently the top-rated student accommodation in Exeter based on student reviews on the Student Crowd website. The excellent reputation of the development has translated into strong demand for the 2023/2024 academic year, with the property currently over 90% let.

Investment Outlook

While more positivity returned to the market in the first half of 2023, the shorter-term outlook for the direct UK real estate market remains clouded on the back of a weaker macroeconomic climate. Gilt yields are anticipated to remain volatile in the short term and any further rise in those yields will result in a tightening margin between UK real estate and gilts, though softened by the previous repricing of UK real estate. Heightened interest rates will also maintain pressure on real estate pricing. On a positive note, debt financing remains available and lender appetite for good-quality assets endures.

Investors are likely to remain risk-off with good-quality real estate providing more resilience in the face of weaker economic conditions and benefiting from more robust supply/demand dynamics. Polarisation within sectors is expected to intensify, with secondary rental and capital values under more pressure than prime. Occupational performance is expected to be the dominant driver of real estate returns in the near term and so the robustness of income will be paramount.

Importantly, polarisation between sectors is also likely to rise with those sectors that benefit from structural and thematic tailwinds, such as industrial and residential, set to benefit over the longer term.

Investors with limited exposure to the office sector, which is facing further capital value declines because of various structural headwinds, look likely to be in a stronger position.

Finally, although the risks to the timing of a recovery remain elevated given the strength of underlying inflation and the associated risk of interest rates remaining higher for longer, an improvement in real estate performance is anticipated in 2024 when we expect UK monetary policy will be designed to stimulate economic growth.

Portfolio Strategy

We will continue to assess the portfolio for opportunistic trading but are happy with its current composition, focused as it is on favoured sectors while offering good geographic and tenant diversification. Our long-term conviction remains towards sectors with structural growth drivers and those with resilient income streams such as industrials, retail warehousing and living assets. Although the Company has financial resources of £123.6 million available as at 30 June 2023, this is primarily via its RCF. RCFs are currently a relatively expensive form of debt and so, given prevailing interest rate conditions, this debt is only likely to be deployed if a compelling and accretive opportunity arises. Notwithstanding the potential for an exceptional opportunity to emerge, we do not anticipate utilising it in the short term to fund further property acquisitions.

As Manager, with the Board, we are aware of the dislocation between the Company’s share price and net asset value. Whilst this is a wider asset class issue it is not one we take lightly. As you would expect, our efforts and strategy revolve around a focus on the areas we are able to control to create the environment where our share price will improve. We believe earnings growth through active asset and company management, a strategic portfolio allocation set for growth and strong balance sheet discipline will create the best foundations for the stock to shine when, or ahead of, a recovery in the real estate sector.

A focus on earnings will create the conditions for dividend growth, with the strong structural attributes of the portfolio – industrial, beds and good retail warehousing – really coming to the fore for growth when an improved macro environment arrives.

Peter Pereira Gray
Chair of UKCM REIT
27th September 2023

Important information

Risk factors you should consider prior to investing:

• The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested.
• Past performance is not a guide to future returns.
• The value of property and property-related assets is inherently subjective due to the individual nature of each property. As a result, valuations are subject to substantial uncertainty. There is no assurance that the valuations of Properties will correspond exactly with the actual sale price even where such sales occur shortly after the relevant valuation date.
• Prospective investors should be aware that, whilst the use of borrowings should enhance the net asset value of the Ordinary Shares where the value of the Company's underlying assets is rising, it will have the opposite effect where the underlying asset value is falling. In addition, in the event that the rental income of the falls for whatever reason, including tenant defaults, the use of borrowings will increase the impact of such fall on the net revenue of the Company and, accordingly, will have an adverse effect on the Company's ability to pay dividends to Shareholders.
• The performance of the Company would be adversely affected by a downturn in the property market in terms of market value or a weakening of rental yields. In the event of default by a tenant, or during any other void period, the Company will suffer a rental shortfall and incur additional expenses until the property is re-let. These expenses could include legal and surveying costs in re-letting, maintenance costs, insurance costs, rates and marketing costs.
• Returns from an investment in property depend largely upon the amount of rental income generated from the property and the expenses incurred in the development or redevelopment and management of the property, as well as upon changes in its market value.
• Any change to the laws and regulations relating to the UK commercial property market may have an adverse effect on the market value of the Property Portfolio and/or the rental income of the Property Portfolio.
• Where there are lease expiries within the Property Portfolio, there is a risk that a significant proportion of leases may be re-let at rental values lower than those prevailing under the current leases, or that void periods may be experienced on a significant proportion of the Property Portfolio.
• The Company may undertake development (including redevelopment) of property or invest in property that requires refurbishment prior to renting the property. The risks of development or refurbishment include, but are not limited to, delays in timely completion of the project, cost overruns, poor quality workmanship, and inability to rent or inability to rent at a rental level sufficient to generate profits.
• The Company may face significant competition from UK or other foreign property companies or funds. Competition in the property market may lead to prices for existing properties or land for development being driven up through competing bids by potential purchasers.
• Accordingly, the existence of such competition may have a material adverse impact on the Company's ability to acquire properties or development land at satisfactory prices.
• As the owner of UK commercial property, the Company is subject to environmental regulations that can impose liability for cleaning up contaminated land, watercourses or groundwater on the person causing or knowingly permitting the contamination. If the Company owns or acquires contaminated land, it could also be liable to third parties for harm caused to them or their property as a result of the contamination. If the Company is found to be in violation of environmental regulations, it could face reputational damage, regulatory compliance penalties, reduced letting income and reduced asset valuation, which could have a material adverse effect on the Company's business, financial condition, results of operations, future prospects and/or the price of the Shares.

Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London, EC2M 4AG. abrdn Investments Limited, registered in Scotland (No. 108419), 10 Queen’s Terrace, Aberdeen AB10 1XL. Both companies are authorised and regulated by the Financial Conduct Authority in the UK.