QMI September 2013

This communication is for investment professionals only and should not be distributed to or relied upon by retail clients.

It is only intended for use in jurisdictions where the relevant funds are authorised for distribution or where no such

authorisation is required.

VESTA – Roman Goddess of the hearth

Quarterly Market Insight

QMI September 2013

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QUARTERLY MARKET INSIGHT

INTRODUCTION

Welcome to the September edition of the Hearthstone Investments Quarterly Market Insight (QMI).

The TM Hearthstone UK Residential Property Fund reached its first anniversary in July and has posted a very

credible return of +4.2% in the last 12 months (source Trustnet 25/9/13, E share class). This compares

favourably to the LSL Acadametrics House Price Index (against which the fund is benchmarked) return of

3.2% in the 12 months to August 2013. The first year performance of the fund should also be taken in the

context of a relatively flat residential property market across most of the UK regions – data suggests that

annual house price growth excluding Greater London was around 1%.

There has been a lot of comment in the press recently about potential house price ‘bubbles’. A lack of

supply and overseas investment is certainly driving prices in Central London to unprecedented highs but

research from most commentators including Acadametrics, Knight Frank and Savills suggests we are only at

the beginning of a longer term recovery in the broader UK housing market – as suggested above property

prices in many regions have fallen in real terms over the last 12 months.

The main focus for this edition is our technical piece on the differences between residential and commercial

property. We hope this look ‘under the bonnet’ is informative and stimulates debate around the respective

merits of residential and commercial property funds.

The recent report from the Royal Institution of Chartered Surveyors (RICS) proposing a ceiling on UK house

price inflation certainly generated headlines and we will summarise the details of the report.

RESIDENTIAL PROPERTY & COMMERCIAL PROPERTY

For the purposes of this report we are comparing a portfolio of private rented UK residential property

with a balanced portfolio of UK commercial (shops, offices and industrial) properties.

Many investors are familiar with commercial property as a source of competitive risk adjusted returns with

low correlations to other major asset classes like gilts and equities. Independent research from companies

like the British Property Federation, IPD and Acadametrics suggests residential property also offers robust risk

and return characteristics from a similarly uncorrelated asset class, but are they the same?

In short no, there are numerous differences that need to be considered and we will aim to summarise some

of the key areas.

Valuation

The valuation of a portfolio of private rented residential properties will be based on capital values, typically

at a discount to vacant possession (VP) value if the property is let. The application of a discount to VP value

stems from the historic relationship between landlords and tenants where the tenant had much greater

security of tenure which made it difficult for landlords to remove them and gain possession of their property.

The introduction of Assured Shorthold Tenancy agreements (ASTs) in 1988 rebalanced the landlord/tenant

relationship and provided landlords with clearly defined rights of repossession. When valuing a residential

property a surveyor will have access to Land Registry data on recent transactions for similar properties in the

same locations, so values provided should be reasonably accurate.

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The value of a commercial property is essentially driven by a capitalisation of the rental income it

generates. The attractive yields generated by commercial property are seen as the primary source of

returns, with expectations of capital growth often somewhat lower than residential.

Tenancy Agreements

Residential property is generally let under ASTs with the responsibility for maintenance of the property falling

to the landlords, who thus have to pay on-going maintenance and management costs out of income

received. The minimum term under ASTs is 6 months after which the landlord can regain possession of the

property having given the tenant 2 months’ notice.

Commercial property is normally let on a Fully Repaired and Insured (FRI) basis with the tenant responsible

for on-going repairs and maintenance and is usually subject to longer term leases (typically 5-10 years) than

in the residential sector although many leases will have break-points at certain anniversaries and rent

reviews, which are generally on an upward only basis. The longer term nature of commercial tenancies can

provide relatively secure and steady cash flow however as the structure of buildings age and occupiers’

preferences change commercial properties can quickly become functionally obsolescent.

These differences in valuation and tenancy arrangements also explain why the net yields from commercial

property will often be higher than from residential and also why investors might anticipate a greater

element of capital appreciation from a portfolio of residential property.

Liquidity

Residential and commercial properties are both physical assets and hence less liquid than assets traded on

exchanges. Residential property offers better liquidity due to the difference in size of the market, lot sizes

and volumes of sales. The shorter term, and rolling, nature of ASTs also gives a residential property fund

manager more flexibility should they need to realise assets.

Stamp Duty

The costs associated with buying physical assets like property can be higher than other assets, although the

disaggregation of stamp duty land tax (SDLT) on bulk purchases of residential property means large scale

investors pay tax on the mean, rather than the aggregate value of purchases. In effect a residential

property fund could buy several millions pounds worth of property but only pay a low rate of SDLT, whereas

a commercial property fund manager would likely pay 4% on most purchases.

Availability

One area where commercial property currently has an advantage over residential property is the number

of established and regulated funds available. Investors seeking access to a diversified portfolio of residential

property have limited options, whilst investors seeking similar exposure to commercial property have

numerous funds available to them.

Government Support

The current government has been pro-active in not only seeking to support the housing market by

stimulating demand through the ‘Help to Buy’ scheme. It has also been active in trying to address the huge

shortage in the supply of new housing both in the private rented and affordable housing sectors through

initiatives like Build Now Pay Later and Get Britain Building, designed to encourage institutional investment in

to residential property. Concerns have been raised about the creation of an artificial property bubble

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however the huge mismatch between the supply and demand in residential continues to present

challenges but also opportunities for institutional scale investors.

Benchmarks

The primary benchmarks for commercial property are provided by IPD whose property indices are based on

valuations and not actual transaction prices, which suggests that they may at times underestimate the true

volatility of the market.

There are a number of indices against which the residential property performance can be assessed, some

of which are based on asking prices or mortgage offers. The availability and use of Land Registry data that

details all completed transactions, including cash purchases, provides a very accurate insight in to the

actual performance of the UK residential property.

Performance

Whilst the dynamics and characteristics of the two are quite different the performance characteristics are

similar and there is a fairly strong positive correlation of returns. Historically, commercial property values have

tended to react quicker to negative changes to the economic environment and research suggests that

residential property is less volatile than commercial, this being said, it is not immune to the effects of

challenging economic conditions, with current house prices in many regions still below the peaks of 2007.

In summary, we believe the evolution of residential property as a bona fide asset class for investors will

continue to develop and that comparisons with commercial property are inevitable. Most analysts will

already be familiar with the commercial property but may be less so with residential. The different

characteristics of each suggest to us that combining the two within multi asset portfolios potentially provides

the potential for competitive and uncorrelated returns.

RICS – BANK OF ENGLAND SHOULD CAP HOUSE PRICE INFLATION?

The crux of the paper is how the new Financial Policy Committee (FPC) should embrace other means of

controlling asset prices (in this case housing) in line with some of the policies used in other countries.

RICS believe this could help avert another house price bubble although they acknowledge the numerous

challenges that any such policies would face.

Overview;

- There would be two main purposes;

o Anchoring private sector house price inflation would curb excessive risk taking and build-up

of financial imbalances

o Legitimising the FPC and enhancing its credibility as an independent unelected body

- The use of ‘macroprudential’ policies to manage house price inflation could be highly targeted and

avoid the wider collateral economic damage that may be caused by increasing interest rates, for

instance

- The principle is not new, many countries use various economic tools to manage their housing

markets

- RICS are quite open-minded about the simplistic methodology used to arrive at the 5% threshold

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- Macroprudential tools are broadly split in to three types;

o Credit related, which could limit bank’s ability to lend in certain areas

o Liquidity related, impacting on how banks fund themselves

o Capital related, which can affect a bank’s ability to absorb losses

- Most other countries have used credit related policies for example, capping loan to values, the debt

to income ratio for each household or shortening the mortgage term to increase payments

- RICS suggest a house price inflation cap could even be imposed at a regional level and there is a

precedence for this in Korea

- Limiting house price inflation is not intended to be a standalone policy

- RICS acknowledge there are risks of several unintended consequences that would need to be

addressed through additional measures;

o Exacerbating the shortage in supply of UK housing

o Pushing more people (like first time buyers) in to the rental market, creating upward pressure

on rents, hence transferring more income from poorer households to potential wealthy

private landlords

o Investors allocating wealth away from housing to other asset classes

- In the lead up to the financial crisis Central Banks only had monetary policies (interest rates) to

control house price growth. However, in banking circles it is commonly agreed that monetary policy

should not be used to influence asset prices because;

o Central banks can’t deliver on two targets (inflation and asset prices) with one tool – interest

rates

o Using aggressive interest rates rises to curb house price inflation could cause substantial

damage to the real economy

o House price growth enriches the electorate and if central banks intervened to curb it whilst

also causing collateral damage to other areas of the economy this could undermine them

o Inflation targeting encompasses asset prices. Asset price growth can drive up inflation which

would then be controlled by the normal process of tightening of monetary policy

- Following the financial crisis an emerging view is that central banks could take an active role in

certain scenarios but with new economic tools at their disposal

o Monetary policy is viewed as fairly indiscriminate, whereas newly created policies could

target specific areas of the economy like the residential property market

- The paper says the creation of the FPC is positive although it is not currently equipped to deal with a

house price boom

- The FPC should have a specific policy on house prices to build credibility and to avoid it being

second guessed

- The FPC will ultimately be judged by many on the health of the housing market

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The RICS report raises various interesting ideas some of which have been successfully implemented in other

countries. The complexities created by regional differences in UK house price movements would present

huge challenges to implementing such a scheme. The report highlights several unintended yet potentially

damaging consequences, in particular exacerbating the current shortfall in housing supply. We would like

to see continued government support to boost the chronic lack of supply in UK housing combined with

sensible mortgage lending to create robust but sustainable UK house price growth.

SUMMARY

We hope this quarters report has provided some food for thought when assessing residential and

commercial ‘bricks & mortar’ investments. We believe professionally selected and managed portfolios of

commercial and residential property both offer diversification for multi asset investors with varying levels of

potential capital growth and yields. The different return profiles coupled with the technical differences

between the two would suggest that it is not really a case of residential or commercial when looking to

allocate to property but more residential and commercial.

The debate continues to rage about the current state of the UK housing market with many of the headlines

warning of an imminent house price bubble. We believe the reality is somewhat removed from the

headlines, a view which is shared by several respected bodies including the Building Societies Association,

the Institute of Directors, the Office for National Statistics and the Centre for Economics and Business

Research.

This communication is for investment professionals only and should not be distributed to or relied upon by retail clients. It is only intended for use in jurisdictions where the relevant funds are authorised for distribution or where no such authorisation is required.

Literature approved for use with retail clients is available on request, or can be downloaded from our website.

This document is not a prospectus, invitation to invest or advice.

Hearthstone Investments PLC is the parent company of the Hearthstone Investments Group. Regulated business is carried out by Hearthstone Asset Management Limited. Hearthstone Asset Management Limited is an appointed representative of Thesis Asset Management PLC which is authorised and regulated by the Financial Conduct Authority (114354). This financial promotion has been approved for the purposes of Section 21 of the Financial Services and Markets Act 2000 in the United Kingdom by Thesis Asset Management PLC.