Property is booming, but will it bust?

Figures from the investment trade body the IMA show that a total of £2.9bn net new money flowed into funds in the IMA Property sector in the first nine months of this year.

Nearly triple the amount of money flowed into property funds than into all fixed income funds in that time, with the sector only marginally beaten by the combined might of the multi-asset Mixed Investment sectors.

While there are a large number of funds in the IMA Property sector that invest in property equities, the bulk of the money has been flowing into direct property funds.

These are funds that buy up office blocks or commercial real estate and then deliver returns for unitholders through a combination of the yield paid to the manager by the users of the building, as well as any capital appreciation of the buildings’’ value.

The reason for the sudden increase in the popularity of the property funds comes down to a combination of the solid yield on offer with base rates still at record lows, and the sudden increase in capital appreciation on the properties.

This uptick in the value of direct properties has seen most direct funds deliver returns of more than 10 per cent in the past year with some even nudging 20 per cent, a significantly above average return for a direct property fund.

‘Hot’ money

The super-normal returns have led some to fear that a large part of the money flowing into the sector may be so-called “hot money” that will leave as soon as this period of capital appreciation ends.

The first asset manager to acknowledge the potential problems of this sudden inflow of money has been Threadneedle. The group’s UK Property fund, run by Don Jordison, has nearly doubled in size so far this year, rising from £447m of assets at the start of the year to more than 850m now.

And the firm has started to become worried by all of this new money. As a result it has it is “monitoring the liquidity” of the fund in order to “protect our existing clients’ interests”.

The firm is understood to have ceased marketing the fund in an attempt to stem inflows, though it has yet to officially “soft-close” the fund.

As well as the risk of “hot money” flowing out of the sector at some point, the managers of some of the top-performing property funds have raised concerns about the sheer amount of money chasing a limited number of direct property assets, leading many managers to make “off-market” deals or invest in unconventional property assets.

Gerry Ferguson, manager of the £3.2bn Swip Property Trust, notes: “Given the strength of the market in recent months there are certainly fewer attractively priced properties that meet our quality criteria”

But Mr Ferguson adds the size of his fund, and the links built up with brokers around the country, meant that he had managed to get access to certain deals that “smaller managers may not be aware of”.

Philip Nell, manager of the £1.8bn Aviva Investors Property Trust, also says his links to brokers have also come in handy in the past year as he sought to avoid the heavily competitive parts of the auction market.

He explains he has so far bought eight properties in 2014, of which “two were in full competition on the market, two were in limited competition and the other four were been completely off the market”.

“So we have managed to buy and not had to buy in competition all the time, which is important because there is a lot of money out there,” Mr Nell explained.

Moving out of the mainstream

While some managers have avoided the crowds by buying off-market, Ainslie McLennan, co-manager of the £2.4bn Henderson UK Property fund, says she has begun to invest in slightly more esoteric assets.

Ms McLennan continues that while “there is a lot of competition” for assets at present, she and co-manager Marcus Langlands Pearse have managed to spend £740m on new properties so far in 2014.

But to do that the managers have bought into areas of the market such as “private hospitals, leisure facilities, cinemas” that are outside the conventional remit of office, industrial and commercial buildings bought by most managers.

Ms McLennan stresses each property still had to meet the managers’ strict criteria and be a good fit for the fund and it was possible to find such assets in unconventional areas.

Managers are having to find innovative ways of deploying the money flowing into their funds into order to avoid ‘cash drag’, where a high level of cash in a fund drags down the overall yield offered to investors.

Most property managers keep at least 10 per cent in cash or liquid assets in order to meet redemptions from investors but the rush of money had seen that level rise in many funds, forcing managers to act.

In spite of the many concerns around the influx of money and the impact on property funds, no-one else has yet taken the step of Threadneedle and all insist on their own ability to still get deals done.

For investors in property funds, the question is whether the easy money has been made or if we might soon see a return to the days when the return from a property fund was just its annual yield.

Opinions are divided on that. Ms McLennan argues the capital gains from property have been front loaded to this year and the start of 2015, meaning the “hot money” may begin to flow out, possibly causing liquidity problems, by the middle of next year.

But Aviva recently hiked its return forecasts for 2015 up to 17.2 per cent, which is likely to follow on from 20 per cent plus performance in 2014.

Either way, investors are ill-advised to dive into property funds for a short-term capital boost and should instead focus on traditional driver of property returns: the long-term stable income stream.

Matthew Jeynes is deputy news editor at Investment Adviser

matthew.jeynes@ft.com