Offices, the high street and warehouses: the new rules of property investing

The pandemic changed the rules on how to invest successfully in property, with commercial and office real estate suffering, while logistics and residential markets took off. 

TR Property (LSE:TRY) investment trust manager Marcus Phayre-Mudge sits down with interactive investor’s Sam Benstead and explains how he has adapted to this new world, and what investments he currently likes that are profiting from new trends. 

He answers key questions on the future of the high street and office space in London.  

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Sam Benstead, deputy collectives editor, interactive investor: Hello and welcome to the latest Insider Interview. Our guest today is Marcus Phayre-Mudge, manager of the TR Property Investment Trust. Marcus, thank you for coming into the studio.

Marcus Phayre-Mudge, manager of TR Property investment trust:Thank you, Sam.

Sam Benstead: The pandemic reshaped the world economy. It had a big impact on the property market as well. So, what have been the big winners and losers since the pandemic, and how are you investing since the pandemic?

Marcus Phayre-Mudge: Well, Sam, it's a great question because it really has been very dramatic for real estate, for commercial property. I mean, the most obvious has been the changes in office markets. We all worked from home 100% and post the end of the pandemic, of course, there's been a whole shift in behaviour. How it's really shaking out, you know, a couple of years later is that companies really need to entice their staff back to the office. They need to provide better-quality facilities, amenities and space.

And there's also a realisation that we do want to come to the office, we do want to collaborate with our colleagues, we do want to meet our customers and clients. But the space that you need has really got to be best in class. Now, that desire and demand has essentially been joined by a government requirement to improve energy efficiency in buildings. So, there's a sort of renewed emphasis on all fronts.

What is really interesting is that some data [that came] out of the US last week shows that the office markets that have seen the strongest rebound and, in fact, net absorption, net take-up has been buildings that have been built since 2015, and every other generation of older assets has lost tenants.

So, we're already seeing this, and we can see the stats here in London. On top of all that, there's been very little new development, which we'll talk about. Of course, the second thing about working from home, of course, is that it has changed the way we shop and where we shop. And, interestingly, we're seeing quite a lot of suburban high streets and small attractive towns, your cathedral cities, etc, those retail markets are doing quite well, but otherwise, none of us really want to sit in a traffic jam on a Saturday morning to go to a shopping centre. So, we have seen that we have all become very much addicted to online [shopping] and that continues to grow. In the UK, we're now up to about 30% of all sales, ex-food and fuel.

Sam Benstead:Commercial property: what share of the portfolio is invested there? And with working from home, have we seen peak work from home? Are people going to return to the offices, or is three days a week about right, and is it going to stick like that for the long term?

Marcus Phayre-Mudge: Yeah, we think that three to four days is almost certainly set to become some sort of norm. Now, the problem for tenants and the positive for landlords is, of course, if you have everybody in the office three days a week, then you must have enough seats for everybody to sit on. So, essentially, it's, you know, are we going to see a collapse in demand of office space? No. Can large companies manage hot-desking? Possibly, but small and mid-caps far less.

What we are seeing is a lot of companies seeking greater flexibility, so shorter leases. Offices that are already fitted out and you can literally just turn the key and press play. And that is where we're seeing a lot of success in the serviced office markets.

As far as our portfolio is concerned, we don't have a lot of exposure to offices in the UK, but we do across Europe. And that's really to do with the fact that a lot of all the smaller cities have seen a very strong return to office. Quite simply, if your commute was half an hour by car, you'd almost certainly go to work. And particularly in the summer, your home isn't air-conditioned, but your office is and you're based in Madrid or Milan, you want to go into an air-conditioned office. Whereas in the UK, if you've got an hour and 20 minutes [commute] and part of it is underground, you are much less likely to return to work. And that's essentially a theme we've seen both in the US and in Europe.

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Sam Benstead: The other big change of the pandemic was online shopping. So, how do you invest in that space? How do you identify winners from the online shopping revolution?

Marcus Phayre-Mudge: Well, that's a great question. And if you look back at the way the portfolio has evolved post sort of 2012, 2014, we were very underweight retail everywhere as we saw the boom in online retailing and the success of the logistics developers, be it Segro (LSE:SGRO), Tritax Big Box Ord (LSE:BBOX), LondonMetric Property (LSE:LMP).

And in Europe we're still exposed to a lot of developers; Argan (EURONEXT:ARG), Warehouses De Pauw SA (EURONEXT:WDP), CTP NV Ordinary Shares (EURONEXT:CTPNV), Montaya. These are names that are relatively small companies and you basically need to have specialist knowledge to invest in them. But we think this is still an ongoing tailwind of demand. This has been compounded from the slowdown, or the requirement to try and reduce the need for “just in time” and everything being a bit more “just in case”, essentially shortening logistics chains and supply chains, which was really exposed during the pandemic.

So, we're still seeing net demand from both businesses and private consumers through online sales. What's really interesting between the UK and Europe is actually how the UK has embraced online, where [it’s] roughly 30% of all sales ex-food and fuel. Meanwhile, for somewhere like Italy, it's only 12%. There's still a really strong desire to go to a physical store and that's a local feature. And we think that will persist.

Sam Benstead: The high street in the UK, is it dead?

Marcus Phayre-Mudge: It's a great question. The answer is no, but it is in serious trouble in certain locations. And essentially, those locations offering an attractive midweek offer, particularly with food and beverages for people who are working from home, or they have another reason, like tourism, cathedral cities, they are doing fine, as are the well-heeled suburbs of all our major cities. Further afield, yes, there are problems. And, really, the government needs to sort out how tenants are taxed through rates, and they need to sort out parking. There are lots of things that could be done and need to be done, but otherwise we're just going to see these high streets almost return to where they were 100 years ago, which is essentially residential streets.

Sam Benstead: What have been your best and worst recent property investments?

Marcus Phayre-Mudge: Well, one of my best investments has been a business called Industrial REIT, which invests in multi-let industrial estates, which are really quite a complex area. These are all the terraces of little sheds, as we call them, that you might find next to your station at home or in the outskirts of every town and city. Often they'll be 20 or 30 units, lots of small tenants, very hard work for a landlord.

But Industrial REIT had been really at the forefront of digitising that management approach. A lot of making it very easy for tenants to walk in with a three-page lease. A really good business and it was busily growing, run by a very dynamic management team, and it was bid for by Blackstone in April this year. Blackstone paid a 40% premium to the then share price.

Now the point of the story is that, essentially, if the listed market is going to undervalue these companies, private capital will come and buy it, because you have to remember that way more real estate is owned privately than publicly.

And we've seen this time and again, and it's a very strong underpin for where pricing is today because ultimately, if these listed companies get too cheap, private capital will come and buy them.

The other success, rather strangely, will be a company I didn't buy and that was Home REIT (LSE:HOME). Home REIT was investing in a very seductive class of a sector of real estate, which was to provide homes for the homeless. Absolutely, we were all very much in favour of that. But in our due diligence, it just didn't pass muster. Now, we weren't aware at the time of what subsequently turned out to be likely to be proven to be fraudulent activity, but it was one that we avoided.

In terms of the least successful. It's been a sector which has got very strong, resilient income, and that would be German residential. I mentioned it earlier that the rents in Germany are controlled. So, essentially all you're paying, if you're a tenant of one of these landlords, is about 30% below open market.

As a result, there's a long queue of people who want to rent these apartments. The problem is that they securitised a lot of this income stream by borrowing in the eurobond market when rates were incredibly low, and that was how they're bolstering their income.

What happened when interest rates shot up, of course, is their earnings collapsed. And I underestimated the speed at which the cost of money would move. So that's been probably our least successful. However, we have seen quite significant recovery in those share prices in the last three months.

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Sam Benstead: Do you still own the sector?

Marcus Phayre-Mudge: We still own the sector, although we're focused particularly on Berlin, which we actually see as a great city where there's a huge amount of organic growth.

Sam Benstead: Do you think we'll see rent controls in the UK?

Marcus Phayre-Mudge: No, I don't think we will. And I think that there is a realisation that quite simply rent controls don't work. If you look at Germany and Sweden, and now you look at Dublin, whether controlled as well, is that you just stymie development. The problem we've got is nobody is building. The private market won't build new homes if they're going to be forced to rent them at submarket rents.

What you need to do is bring in a social contract, which helps tenants understand that they're not going to be exposed to bad landlords. So, we need to grow a private rented sector in the same way that we have purpose-built student accommodation, that works very well, that's all privately funded. And the next generation of students are living in much more superior accommodation than certainly I did in the 1980s. More like something out of The Young Ones.

Sam Benstead: You mentioned the takeover of Industrial REIT by a big private equity group. Are we going to see more activity of this type in the UK-listed property space?

Marcus Phayre-Mudge: I think so, yes. We have always specialised, but as an investment trust, as a closed-ended permanent capital vehicle, I've been fortunate enough to be able to take positions in lots of small companies which might be, on the face of it, quite illiquid. And, essentially it's a well-tested format where we either help these companies grow, or we find that they are unable to grow and then they ultimately are either amalgamating with others or they get taken private. So, this year already we owned 10% of CTPT, which was acquired for paper by London Metric.

We owned 18% of Ediston Property, which is a retail warehouse specialist, and the board carried out a strategic review and I was hoping that they might amalgamate with another listed company so we could keep the assets in the listed space. In fact, the assets have remained in the listed space, but they've been acquired by Realty Income Corp (NYSE:O), which is an enormous US REIT.

So, the assets are in the listed space, but they're in the US market rather than the UK. But I think that we will see more, and I would expect it to be amalgamation rather than privatisation. I think private equity has had its wings clipped temporarily. The cost of money is too high. But I think there are a lot of small property companies that would really benefit from a merger. Another good example where we held 10% of the company was McKay Securities, which was acquired by Workspace Group (LSE:WKP). And in fact, you know Workspace took on very few of the McKay employees because, essentially, it already had the workforce to manage the assets.

Sam Benstead: Finally, the question we ask all our guests, do you personally invest in your trust?

Marcus Phayre-Mudge: Absolutely. And I have done since I joined the team in 1997 and obviously a lot more since I took over running the trust in 2011. After my house, it's my next largest investment and my wife has it in her SIPP and the children in their Junior ISAs as well.

Sam Benstead: Marcus, thank you very much for your time.

Marcus Phayre-Mudge: Thank you.

Sam Benstead: And that's all we've got time for today. You can check out more Insider Interviews on our YouTube channel where you can like comment and subscribe. See you next time.