The difference between funds investing directly in property and funds investing in property shares

10th September 2014 by The Harried House Hunter

Property has become fashionable once again over the previous 18 months. The once maligned sector, which was characterised by large drawdowns and daily liquidity being suspended, in some cases, during the financial crisis, has two funds in the top 10 for net inflows in the seven months up until the end July of 2014. What has brought about this change? Well, I think it started as a relative yield play. With bond markets trading at record highs and equities suffering from yield compression, property became an attractive source of income. This, combined with the fact that it was still reasonably cheap, made the asset class all the more desirable. In recent months, as money has poured into the sector, so has confidence, with many managers reporting that commercial property prices (even outside London) are back on the move again. However, up until now I have been talking about physical property funds. Property security funds, that invest in listed property companies, have not only matched the performance of their physical counterparts but were also the third best performing asset class after gold and oil over the previous 10 years*.

What are the main differences between physical and indirect property ownership? In physical property funds the fund manager takes ownership of the asset and is responsible for its upkeep, renovations and finding tenants. This requires an in-depth understanding of the property in question and the local property market. They also need the infrastructure to manage the property. Due to the illiquid nature of the underlying investments, these funds typically have to hold 15-20% cash to fund unit redemptions, which acts as a significant drag on performance. However, as property prices are determined by surveyors and not the market, they are less prone to be affected by the hopes and fears of market participants, and consequently these funds typically exhibit exceptionally low volatility. In essence, they provide genuine asset diversification, as the underlying assets are buildings not equities.

Property securities fund managers on the other hand will look to construct a portfolio of REITs, or Real Estate Investment Trusts. REITs are run by a management team who buy and sell properties that fit their investment strategy. The job of the property security fund manager is to identify the right properties or portfolios of properties, but, crucially, they need to identify the right management teams. As the underlying investments are much more liquid it enables the managers of these funds to exploit shorter-term mispricings and also they can hold less cash. It is also easier to build a diversified portfolio as they can take smaller stakes and also more practical to invest across borders. The end result of this is that, over the short term, property securities exhibit a high correlation with equity markets, but over longer time periods this diminishes and they tend to follow the property market. Consequently, these funds exhibit greater volatility than their physical property relatives, but tend to outperform over time.

In summary, this often overlooked sector offers a more flexible way to get property exposure and could complement a holding in a physical property fund. As for property as a whole, pension funds currently only have around 3.8% exposure to property, versus a long-term average of around 10%, which suggests there could be more upside. Also, with the sector booming, many properties are experiencing rental growth, which means the property owners will be able to pass on the effects of any interest rate rises to their tenants. All in all, property, whether physical or indirect, for the time being at least, looks like a decent place to be.

 

*Period to end July 2014 Source: FE Analytics

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’ views are his own and do not constitute financial advice.

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