Commercial property funds – buy, sell or hold?

31st January 2013

Before the economy sank into the doldrums, commercial property was considered an attractive sector and advisers frequently recommended it as as dependable and profitable part of a diversified portfolio. So is it time to reconsider this asset class? Financial journalist Harriet Meyer asks the experts.

Over recent years, news of sinking returns from commercial property funds will have shaken investors who might have considered including the asset class in their portfolios, with empty offices and shops hitting returns.

Experts urge caution about the asset class and say investors need to understand what they are buying before they do so, but they stress that it can prove a good diversifier and income-generator – despite poor performance over recent years.

Patrick Connolly, certified financial planner at AWD Chase de Vere, said: “Investors are not particularly enthusiastic about commercial property today and there is a risk that it may significantly under-perform equities if stock markets perform well. However, we are holding property for the long-term alongside, and not instead of, equities.”

Investors suffered during the crash of 2007 and 2008 when property values started to fall, with funds run by managers such as New Star and Aviva imposing exit restrictions due to liquidity problems. That can be a problem with open-ended versions of the funds. When faced with investors trying to cash out in large numbers, the funds may struggle to find the cash to allow them do so, though generally such issues shouldn't affect closed ended investment trust structures.

Performance has also been unspectacular.

According to housing investment and shared equity mortgage provider Castle Trust, property investors have seen their holdings fall on average 11.4 per cent over the past five years. Analysis of returns from 42 funds in the IMA Property Sector showed the worst fund lost 26.6 per cent over the period.

Sean Oldfield, chief executive officer of Castle Trust, said: “The reality is that investors try to sell when prices turn down, at which point they are locked in and then get the prices that can be achieved for the properties when allowed out. 

“The idea that an open-ended fund can make illiquid assets liquid is misleading, as anyone who tried to sell a holding in a commercial property fund in 2008 will be aware.”

However, big pension funds are showing signs that there could be an upturn in this asset class with Caisse, Canada’s largest pensions company, planning to buy $10bn of property to boost returns.

With rental yields currently sitting at 6 per cent, compared to the average FTSE 100 company which pays an income of 3.5 per cent, could the future be bright for those brave enough to invest? Some advisers also emphasise that investors should not just consider capital growth but also the income potential.

Darius McDermott from IFA Chelsea Financial Services says: “Modest capital depreciation continues to be outweighed by the sector’s high income return, resulting in small but positive total returns. Pre-2007 property investors were more interested in capital growth, now they are looking for income, which has shifted the emphasis to retaining tenants and maintaining steady income.

“The key exception to this overall synopsis is the Central London office market where sustained international appetite and a more healthy leasing market continues to generate stable or fractionally rising values.”

Yet while the outlook for the UK economy remains debatable, property in general may continue to struggle with big-name retailers such as Comet, Jessops and Blockbuster shutting up shop this month while adminstrators attempt to reorganise HMV but with some closures inevitable.

Hargreaves Lansdown's Danny Cox says: “Banks are still deleveraging and have an excess of commercial property loans on their books. The secondary and tertiary markets, already in the doldrums, could face potentially distressed sales (from the likes of RBS, Lloyds and the public sector) as part of cost cutting measures and a response to the sovereign debt crisis.

“We aren’t sure whether this will ever turn into full fire sales but it is a reason to be cautious. There is likely to be an excess of property in many areas, which could put pressure on rental income and capital values. Fund managers have to be careful to avoid rental voids and concentrate on strong areas.”

However, Connolly adds: “Commercial property can provide consistent longer-term returns, and this coupled with its diversifying nature, providing some protection from stock market falls, means that we typically recommend an exposure of between 5 and 12 per cent in client portfolios.

“The important factor is to understand where a property fund invests. Some invest mainly in the shares of property related companies and don’t buy any actual buildings where as others will invest predominantly in actual ‘bricks and mortar’ properties.”

Adrian Lowcock from Hargreaves Lansdown says investors also have to way of 'cash drag' as property funds need to hold some cash in their funds to be able manage inflows and outflows. “Because of low interest offered in cas
h at present this can have a significant effect on the portfolio. If a fund has between 10 and 20 per cent in cash it will bring down the yield.”

Turning to fund recommendations, Cox favours Threadneedle Property, as managers Don Jordison and Chris Morrogh take a conservative approach, preferring properties with above average yields and those located in strong niche markets.

Connolly also recommends defensive funds including Henderson UK Property, Ignis UK Property and M&G Property Portfolio.

Keith Macdonald from IFA Broadway Financial Planning adds: "Another option is investment through publically listed real estate investment trusts – REITs. I’d recommend these, given the drawbacks of the other routes into the asset class, as REITs provide a liquid and relatively low cost way to access global commercial real estate.”

Whatever route investors choose, commercial property is not insulated from the contagion of negative influences emanating from global economy.

While there is an argument that there is still a place for this asset as part of a balanced investment portfolio tread cautiously, this unlikely to be a place for particularly risk-averse investors. For those who understand the risks, advisers say there is still a case to made.

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