185. Inflation proofing, the future of office space and the green building super cycle

TR Property Trust manager Marcus Phayre-Mudge talks us through how his portfolio has navigated the challenges of inflation and which sectors have benefitted best in this scenario. He also runs through the prospects for the office sector post Covid-19 and why we may well be set for a green building super cycle. He also explains why he sees greater potential for shopping centres in Europe over the UK and why he is bullish on the co-living sub-sector.

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Managed by Marcus Phayre-Mudge, the TR Property Trust has a lineage that dates back over 100 years. The portfolio invests in the shares of property companies of all sizes, typically within Europe and the UK. It will also have a small amount invested in physical property in the UK. Marcus looks for well-run businesses in sectors including retail, office, residential, industrial property and alternatives. It is an excellent long-term performer and has stood up well to the inflationary challenges we’ve faced recently.

What’s covered in this episode:

  • How the trust has managed to negate the threat of inflation
  • Why the Supermarket Income REIT has been resilient during inflationary times and why the healthcare sector has struggled
  • How the misty outlook for office space in cities has finally cleared and why the sector may not suffer as much as some previously thought.
  • The potential for a green building super cycle in core markets globally
  • Looking for buildings with “good bones” when it comes to green buildings and why private equity can underpin the listed property market
  • Why shopping centres in Europe are much more attractive to invest in than those in the UK
  • How the evolution of click & collect can benefit the retail warehousing sector
  • The growth of co-living as a sub-sector of the property market

31 March 2022 (pre-recorded 28 March 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.


Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. Today we’re focusing on the property market, both in the UK and in Europe. We look at property in times of inflation, the impact of the pandemic on office spaces and the possibly of a green building super cycle in the future. 

Darius McDermott (DM): I’m Darius McDermott from FundCalibre and this is the Investing on the go podcast. Today I’m delighted to be joined by Marcus Phayre-Mudge, who is the fund manager of the TR Property Investment Trust company. Marcus, good afternoon, how are you?

Marcus Phayre-Mudge (MPM): Hi Darius, I’m well thank you. 


DM: Good. So look, a real difficult time for investors, inflation’s going through the roof. I get asked every day, how do we inflation proof or protect our portfolios, and everyone’s talking about gold, they talk about commodities, and here we are with boring old property. Yet, I’ve had a little sneaky look at your numbers from the end of last March and your NAVs up 19% — looks like you’re ticking the inflation bucket Marcus, what do you think?

MPM: Yeah, Darius, I think it’s absolutely right. The real estate, you know, at the end of the day, it is a real asset and that is fundamentally going to help it hugely as a form of defense, but much more importantly, you’ve got to look at the evidence and the evidence is really all around index linked income. How much of, you know, at the end of the day, the value of your real estate is a product of what you can earn off that piece of commercial property, residential property, land, et cetera. And at the end of the day, all of our European exposure is indexed linked and in the UK, the vast and ever increasing percentage, and we are particularly focused on businesses like LXI, Secure Income REIT, healthcare names, self-storage. These businesses have been really very much keeping up with inflations. You’ve got that index linked income stream. 

But behind all of this, is a realisation that actually the cycle is crucial. And we’ve looked at a lot of data and in the very short term there is not a lot of inflation linkage, medium term, longer term absolutely is, particularly as long as you are calling a particular sub sector correctly. So if you’ve got a sector that’s sort of in decline and I would use what, the experience that we’ve had over the last decade of declining values in shopping centres, we think that may be bottoming out in some places. I’m sure we’ll talk about it in a minute, but yeah, those areas doesn’t matter if inflation’s high or low, they’re going down in value, but many other sub sectors, if you’ve got a much more ambient market dynamic, then you will find yourself with decent inflation proofing.

DM: I know you like LXI and a couple of other names that we follow separately to your trust. Do they have full index linking, or are they sort of capped at 4% or 5%? So they capture the majority or is it a balance of those?

MPM: That’s a great question. And the answer is absolutely they are, they are capped. So you, you know, if inflation is rampant, then you are going to have a problem, but that isn’t going to be your biggest problem. In a scenario of very high single digit or dare I say it, double digit inflation growth cannot keep a up with that. That will be, that is a stagflationary environment, that is bad for all risk assets and real estate is not alone in that. Where it is a particular problem is actually in parts of say healthcare, which have struggled to even deliver kind of CPI and certainly not RPI level of indexation. And here you’ve got to look, you know, it’s all well and good having a lease that’s index linked, but ultimately can your tenant, can your counterparty afford to pay those rents? And that’s where we particularly careful. 

One of the reasons we like Supermarket Income REIT is we found that the large supermarkets have managed to increase their margins and they do so in a…when you get a food inflationary environment that they actually do manage to expand their margins very slightly. Whereas healthcare is proving particularly difficult because the costs are going up everywhere. I’m afraid this is a, one of the direct consequences of Brexit. There’s been the loss of European qualified staff.

DM: Yeah. So we’ve done podcasts. I remember doing vividly one with you the summer of 2020 post COVID. And we talked about the losers and the losers getting weaker and the stronger getting stronger, i.e. logistics and all those fine things. 

Let’s have a little talk about offices. Now, offices minding their own business. Some are regions are expensive, some are cheap, and then comes the pandemic. And I can see by the look of your screen and my screen, you and I both current working from home today as is this new hybrid world. What’s your view on offices? Are we ever going to where we were and what does it mean for the sector? Again, I know you’re a pan European investor, so let’s talk about Europe as well as just the UK.

MPM: Yeah, well it’s, I would say that the fog and the mists are clearing in terms of the qualification of our outlook. And we’re what it’s really working out to be is it’s all about the relationship between the employee’s desire and need to go to travel, to commute, to somewhere, is the environment they’re going to that much better and more valuable for them than sitting in their own domestic environment. And we see this very clearly in the tradeoff between the difference between London and Paris over in sort of one camp and pretty well, every other smaller European city be it Gothenburg, Berlin, Stockholm, Munich, Madrid, Barcelona, Milan, where we’re seeing and some of the smaller French cities, Leon, Marseille, where we’re seeing very high levels of return to office. 

If you look at BMO’s own offices in across Europe, very, very high levels of return to office. And that’s quite simply because your commute is short and you get a lot out of the working environment, working and collaboration with your colleagues. 

So what do we expect to see? We expect to see some impact, particularly in larger cities, but we don’t think that impact will necessarily be, felt hardest right in the core. And we’re already seeing this, if we look at Paris CBD, rents are rising there, compared to what’s going on in the periphery, in France, and further afield. It’s the same in central London. We’re actually seeing the West End, core City, responding well. Docklands not doing so well and some of the sub regional markets are proving difficult. There is going to be a change, but for most of us, we do not want to go and work only from home. We want to have this hybrid. So then it’s a question of, is your desk in the office empty when you are not sitting in it? Cause you’re sitting in your, on your desk at home or are you really going into a full-time desk sharing arrangement and that’s of course the case for much larger companies, they’re able to do that and be able to manage that process more thoroughly.

But what we are absolutely seeing, if you think that every single large corporate, you know, essentially across the globe are signing up to a much, much better emissions management of their, of their carbon emission and other green criteria. And that applies to real estate that they both own and occupy. And you know, we’re certainly aware of a serious shortage of prime grade A real estate, office space that fits a lot of this criteria. And we think that we expect to see essentially a green building super cycle emerging in certain core markets across the world. 

That doesn’t bode well for a lot of brown buildings that will require money to be spent on it. And let’s face it, the cost of the air conditioning unit in central London, it’s the same bit of kit in a market where the rents are a hundred pounds of foot, as it is if you go into, you know, somewhere, much more peripheral or even regional market where rents are 20 or 30 quid. So the economics just don’t stack up.

DM: So look, you’ve touched on big buildings and emissions and air conditioning units. I was talking to another fund manager last week, and one of their favorite stocks is a European stock, which is reducing the output or the climate amount of difficulty that air conditioning does. 

Let’s talk about buildings. And I think you touched on the green buildings super cycle. What exactly does that mean? I mean my understanding is that buildings count for a third of global gas emissions, seems quite high and surely there’s something that can be done in some of these areas.

MPM: Absolutely. So looking forward, you will find that there’s been a huge amount of evolution in not so much in construction techniques, but certainly in M&A and in the quality of insulation in buildings, but remember, there’s a huge amount of embedded carbon in the construction of assets that buildings are already built. And essentially what you’re looking for are buildings are with what we call “good bones” i.e. when you strip them back to their frame, have you got that floor to ceiling height that allows you to then put in retrospectively fit a new air handling air management. You want to put in new windows that open, but they’re going to be triple glazed. You’re going to use ground source, heat pumps are going to use air source. You’re going to use solar. 

And more importantly, the environment that your tenant wants, you know, will involve you know, many more showers, many more cycle bays, as much outside space as they can get, et cetera, cetera, all of which has a cost, but potentially a value. And remember that when you look at the cost to companies operating in a using office space that the cost of their top line that they’ve spent the overhead of the space compared to the overhead of staff are completely inverted, i.e. cost of people’s gone up and a up and cost per foot for office spaces gone down and down, mainly because we’d be able to increase densification. Now as a landlord, it’s music to our ears if we think that we’re all going to reverse that densification, i.e. we’re going to not squish as many people in. And actually our corporates are going to spend more money, spend it better there possibly on space for their employees, particularly as they’re sharing some of that cost as the employees sitting at their home office, which the company isn’t paying for part of the time. So there’s lots of moving parts. 

And I think to say, you know, the office is dead is certainly wrong. And if we look at you know, there’s been some very large private equity that certainly agree with us. We’ve seen in the last month Brookfield buyout Alstria, which is Germany’s largest one of its largest office listed office owners. And then last week they’ve just bid for Hibernia. We were fortunate to own just over 3.5% of Hibernia. So the share price went up by nearly 40% in a day. Now, whilst that’s a short term pop for investors in TR Property, that begs the question, well you’re losing companies to private equity, which we are and that is also a problem, but the neat segway is into the fact that, you know, for investors, that’s a big green flag in terms of, hey there’s a big underpin for listed property companies here, but cause if the stock market allows these companies to get too cheap then private capital will come in and buy them. So it’s a superb underpin and investors should take, you know, a lot of confidence from these transactions and there have been, you know, several others which we can talk about as well.

DM: Very interesting. We touched very briefly on shopping centers and your comment earlier about sort of a structural decline. Yet I see one of the trust largest weightings is to European shopping centers. How do they differ from UK shopping centers? Is it just on valuation yield or are they thriving in a different way than we see on our high streets?

MPM: Yeah, that’s a great question. And quite simply the answer is yes, they are different. The UK shopping centre model was one from the 1950s onwards was essentially a shopping centre anchored by one or two department stores and then surrounded by, you know wings of ordinary standard shopping units. Europe’s completely different. They’re anchored by hypermarkets, so your food, whereas in the UK, your Tesco’s and your Sainsbury and your Waitrose, et cetera, physically, very physically separate, some are attached to shopping centres but the vast majority aren’t. On the continent it’s very different. You think about your last holiday in France. You go to the casino or the clerk or whatever, and you have, you know, the shops around that. So the second area more pressing one in the UK was the five yearly upward rent review. The basically meant that for the last 25 years have been rising up and up and up in UK shopping centres and really to unaffordable levels. 

DM: Yeah. 

MPM: And it took essentially it took a crisis both the GFC [Great Financial Crisis] and then subsequently internet and then the pandemic to really accelerate the fact that rents need to be rebased. On the continent they have always been very much index linked and you’ve had a much closer relationship between turnover and rent. And that’s why for us shopping centres in Europe are much more fairly valued. As far the tenants are concerned. 

The second aspect then is the price of the equities. Now I’m not a big flag waiver of shopping centres per se, because they’re not convenient. We can do so much online, et cetera. I’ve had very little retail exposure for many years, but today I can buy European shopping centres off implied yields of 6.5%, 7% trading at 30% discounts through asset value, Euro Commercial, one of our top names and produced its numbers last week. So vacancy of 1.5% virtually no rental arrears whatsoever trading, as I said, at a 25-30% discount to its asset value. So very, very, very happy based on the difference between the UK and Europe, but more importantly on valuation fundamentals, because lots of investors are like ah it’s retail. I don’t want to own it, but our job is to turn over every stone and to find those gems.

DM: So look maybe a couple of last questions then, and we’ll start on with your view on click and collect rather than home delivery, back in good old UK as an area that you’re more positive on/

MPM: Yeah, absolutely. I think, I mean, as we all try to minimise our carbon usage and our carbon footprints, one of the most obvious one is, how many times a van turns up outside your house, deliver a package you know, the size of a shoebox. The fact of the matter is the retailing community and us as consumers need to increasingly get to the point where we are being essentially rewarded in a different pricing point to go and collect the goods than to have them delivered to our homes. And that is happening all the time, we’re incentivized certainly by the supermarket to click and collect. And the fact that you’ve can now pick up, you know, other packages from your supermarket, et cetera, so where you’re shopping regularly, and I think that’s going to evolve. And that’s really feeding through into retail warehousing because that is just, you know, the most obvious physical retail exposure, edge of town, convenient, free parking, and they’re doing really, really well and we’re seeing really quite decent signs of rental growth in retail warehousing. So we’re very encouraged. We own quite a lot of business called Ediston, which is your, the UK’s only pure retail warehouse REIT.

DM: Okay. Maybe then just to close a couple of other sub sectors that I know you are interested in one is healthcare and the other is co-living. Could you just give us a moment or two on each of those.

MPM: Yeah. Healthcare, the problem with healthcare is it cover covers quite a lot of areas. We’ve got primary, you’ve got elderly, you’ve got retirement living. And really what we like about this, ultimately the fundamental is it’s needed, it’s necessary, it’s vital. And then it’s just a question of, are you buying at the right price and the right cycle. And you know, we think that we’ve seen some very good numbers from certainly from elderly living, particularly where you find the right operator is offering, you know, because there’s a lot of retirees who want, can afford to go into good quality retirement living, and that’s an area. So the higher end, we’re much more focused on that end through businesses like Target Healthcare. 

Europe, of course, has had this horrible issue around Orpea, which is a nursing home operator, well, as of this morning, I think the French state now indicted the company and there’s going to be a court case. But really a very, a very badly run business, a lot of financial irregularities, but when you drive to the core of it, the margins were just too thin, and that is what’s forcing these companies that, you know, so do I want to be exposed to where I come back to ultimately the counterparty risk in your tenant, can they afford to pay the rent and if the rent moves too high then of course, that’s not really somewhere you want to be. 

Co-living, I think is very interesting. And whilst UK’s first sort of co-living REIT, the capital raised was pulled because it coincided with the start of the terrible events in Ukraine. It may well come back. It may not. But we are certainly looking at another one that’s going to be IPOing coming out of Spain. And I think it’s just very much the way forward people want to have that flexibility, in the same way that as students, you and I you know, dreadful places that we were forced to live as students, whereas now you you’ve got 40% plus in purpose built much, much better environment. And given a choice people will go to a purpose built accommodation and same applies to co-living the opportunity to have that shared experience, but also your own space. But with the flexibility and a professional landlord and institutional landlord who isn’t suddenly going to ring you up and say, right, your lease is coming to an end, your rent’s going up by 15% or sling your hook. You’re going have a much more, and that ultimately is attractive. And it’s about the institutionalisation of a particular sub-asset class.

And we remain very positive about the private rented sector in Germany and in Sweden or albeit right now stock markets are saying rates are rising. These are bond proxies, share prices must fall. But my point is, we’re now looking at share prices like Bonno trading at huge, huge discounts to its asset value. Yes, earnings growth is going to be the little bit anemic for a while, but fundamentally this is a really solid long term value. You cannot build these portfolios for the price that the share price is trading at. They’re way, way, way below rebuild cost.

DM: Marcus, thank you very much. I always find talking to you, you think property, but it’s got so many sub sectors geographies. You know, when I start covering property 20 plus years ago, it was offices, retail and industrial. And now, as you said, we’ve got co-living and last stock REITs and you know, all sorts of other fantastic investment opportunities. So, Marcus, thank you very much. 

MPM: Thank you very much. 

DM: Brief takeaway from myself, given the high inflation and the NAV return on this trust, I think is good evidence. I think your words earlier of index linked income, is really key. And maybe just a final closing words on the bit we talked about the green building super cycle, you know, it’s good for the environment. It’s good for the tenants and as you’ve proved it’s good for investors. So three ticks across the board there. So, Marcus, thank you very much for your time this afternoon. This is the Investing on the go podcast. If you’ve enjoyed this podcast, please do remember to subscribe and like. 

SW: Marcus has been running the TR Property Investment Trust for over fifteen years investing in the shares of property companies of all sizes, typically within Europe and the UK. As this podcast as covered the manager covers a range of sub sectors including alternatives such as student accommodation, self-storage and healthcare. To learn more about the TR Property Investment Trust visit fundcalibre.com – and dont forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts. 

Please remember, weve been discussing individual companies to bring investing to life for you. Its not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibres research methodology and are the opinion of FundCalibres research team only.

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