UK commercial property has been a popular asset class for the past few years, and the ‘hunt-for-income’ theme has led many investors to look favourably on a sector that has been yielding more than broad equity and bond markets.
However, a wave of money into the asset class has caused prices to go up, collapsing yield differentials. Putting numbers on this, commercial property has made a quite phenomenal 51.5 per cent total return over the past three years, around half of which has been accounted for by capital price appreciation, while yields have fallen to 3-4 per cent for a typical property fund.
The outlook is now considerably more subdued, and momentum seems to have turned, with data from the Investment Association showing accelerating net outflows from the property sector in January and February this year after three years of net inflows.
With open-ended physical property funds a popular investment route, this leaves many investors exposed to ‘swing pricing’, a timely reminder that property is an illiquid asset class.
As a result, investors can be quite indignant when the price swings against them and they see a sudden 5 per cent or more drop in the paper value of their holding. The mechanism is designed to protect existing investors in an otherwise illiquid asset class by pushing additional trading costs – which can be significant – on to the net buyers or sellers, with a side benefit of providing a disincentive to the trend investor.
The exact mechanism varies from fund to fund, but generally there is just a single price that all buyers and sellers trade at. If there are net inflows, this price will be a bit higher than the NAV of the underlying assets to cover the costs of buying more properties, and if there are net outflows the price will swing to a price below NAV to cover selling costs.
Given the outflows we’re now seeing in the sector, I – along with many of you, I’m sure – am now seeing a lot of my preferred funds swing their price, and investors asking if they should wait for it to swing back before selling.
I think this is the wrong way to be thinking, and physical property funds shouldn’t be used as frequent trading vehicles. It’s even more important in commercial property investment to think about your time horizon, and separate a long-term investment view based on the asset class from short-term trading and trying to game the fund structure.
The latter isn’t good for investors or the fund managers – only for brokers, lawyers and the government, who get the fees and taxes.
In my opinion, investors should take a long-term buy-and-hold approach to their core physical property exposure. On top of this, investors can use a ‘buffer’ to express tactical views using more liquid instruments such as property securities funds, Reits, or some of the new ‘smart beta’ passive solutions.
You shouldn’t let short-term swinging prices influence your long-term investment views – but don’t forget about liquidity, in good times as well as bad.
Ben Seager-Scott is head of investment strategy at Tilney Bestinvest
