Commercial property funds have certainly gained traction with investors allocating billions of pounds into these over the last year.
Much of this has been driven by the emergency interest rate environment, which has pushed income investors into higher risk assets over the years. Bonds and then equity markets were the initial beneficiaries but such has been the demand for income, that yields in these areas have compressed.
Now that there is increasing speculation over rising interest rates, investors have been reducing their bond exposure in favour of property. In addition, recent stockmarket volatility has seen investors become scared of committing more money to equities and the focus has returned to lower risk assets with many viewing commercial property as a safer haven.
Commercial property funds are proving extremely useful for two main reasons: they are generating an income that is relatively attractive versus other asset classes; they are displaying a distinct lack of correlation with equity and bond markets.
In reality, investing directly in a portfolio of office blocks, factories and shops is unrealistic for most private investors and exposure to this area is best achieved through pooled collective investment funds, such as unit trusts, Oeics and/or investment trusts.
However, there are different ways to invest in property, the most common ways are:
• To invest in a ‘bricks and mortar’ property fund
• Invest in property shares
• Invest in a real estate investment trust
The latter two can provide an attractive level of income currently but as you are, in effect, buying shares in property companies, they are more correlated to economic and market sentiment. As such, they are subject to the vagaries of the stockmarket and the inherent risk this brings.
Therefore, to adequately gain the two desirable attributes of an attractive income and diversification, the best approach is to invest in ‘bricks and mortar’ property funds.
The majority of property funds are unit trusts. However, some property funds have converted into a Property Authorised Investment Fund.
A PAIF is an Oeic that can provide favourable tax treatment for investors. PAIF rules were introduced in April 2008 by HMRC as a way of enabling investors to receive income gross, rather than net of tax.
Within a property unit trust income is derived from several sources, including rental income and interest. Normally, all income distributed to investors from the fund is treated as a dividend distribution, which is paid with a non-reclaimable tax credit.
In contrast, although a PAIF will make one aggregated income payment also, it is required to divide income in to three separate parts for UK tax purposes – property income (mainly rental income), interest income, and other income from the PAIF usually treated as dividends.
Identifying each separate part of income allows each to be treated differently for tax purposes, with both property and interest income to be paid gross. This is particularly beneficial for Isa and pension investors.
Not all open-ended property funds are PAIFs, although more and more are looking into converting into one.
While commercial property is driven by the economic cycle, its inelasticity and the lag associated with the property cycle means that it does not fluctuate in the same way as other assets. Commercial property also has little relationship with residential property, and the house price boom is of little relevance to commercial property investment.
The fact that commercial property is a tangible asset, still owned even if a tenant defaults, provides a measure of security for investors. On these grounds alone property has a place in a well-balanced investment portfolio. However, exposure should be limited and it is not unreasonable to allocate 15 per cent of capital within an income-focused, diversified balanced asset portfolio.
The range of property investments vary dramatically and the risk profile attached to a particular property investment will depend on a number of factors. If seeking core exposure to the sector for income and for portfolio diversification, the following factors should be considered:
• Exposure to property should be skewed towards direct property as opposed to property shares. Funds investing in property shares are subject to the volatility of the equity market and therefore have a different risk/return profile.
• The investment should have a widely diversified portfolio of properties. This should include a broad spread of sectors (for example, retail, industrial and office) and regional diversification.
• Property is viewed as a low volatility investment and therefore it is not prudent to utilise property funds employing significant gearing (for example, Reits).
• Experienced management. This is a specialist area of investment and the management must be able to demonstrate expertise and a demonstrable track record.
• Property should be viewed as an illiquid part of a portfolio. Although as long as property is a small portion of your portfolio, that should not be a major problem.
After a bumper year in 2014, returns from the UK property market in 2015 look likely to be good again, with many property fund managers predicting a total return for the IPD benchmark being around the double digit mark.
However, most experts and property fund managers believe that next year we will begin to see property reverting to its traditional income-driven behaviour and growth will be driven by rental growth rather uplifts in capital values.
Despite the increasing demand for commercial property the UK is not at the end of the cycle just yet. The ongoing UK economic recovery plus the relatively high levels of income combined with the spread of rental growth across the country, all serve to make property investment an attractive prospect, particularly in comparison with other asset classes.
Ben Willis is head of research at Whitechurch Securities
