Advantages and disadvantages of property funds

UK open-ended commercial property funds are by no means small fry in terms of assets under management - the Investment Association’s Property Sector has an average fund size of £588m, while some have billions of assets under management (see table).

Easier to manage

One of the big features of a commercial property fund is that the structure itself - whether it is a Property Authorised Investment Fund (Paif) or not - can be efficient to manage.

These funds could invest directly into property, which means a manager of a £1bn commercial property portfolio could have just 100 properties within it.

This is much easier to manage administratively than a vast portfolio of maybe thousands of residential properties.

A commercial property fund could also invest in shares issued by listed property companies or in underlying property managers, who have expertise in their sectors.

The rent is like a bond in the sense the rent is payable in all market cycles, and leases only allow rents to go up Phil Clark

But administration and management aside, what makes commercial property good for managers may not be what makes it good for investors.

Range of underlying assets

Adrian Lowcock, investment director for Architas, says: “These funds give investors exposure to assets they could not buy directly, as these are business properties, and give investors access to the UK or global economic growth.”

According to James Carthew, head of research for QuotedData, this is a big draw. “Commercial property funds invest in offices, retail, leisure and industry property - just about anything that would not be classified as residential or infrastructure.”

Leases and yields

Leases tend to be longer on the underlying property, often with high-quality tenants, such as government bodies, which makes this sort of vehicle suitable for a long-term investment.

Commercial property lets usually have pre-agreed rate increases, which in itself could help to hedge against inflation, as well and providing a good yield.

Ben Willis, head of research for Whitechurch Financial Consultants, says: “A big driver for commercial property has been its income stream.

“Property has provided relatively attractive yields compared with government bonds.”

According to Phil Clark, head of property investing at Kames Capital, “The rent is like a bond in the sense the rent is payable in all market cycles, and leases only allow rents to go up (if the rental value of a property has risen since the last rent review), not down.”

In its 2015 paper: Implications for Property Yields of Rising Bond Yields, the Investment Property Forum showed how UK gilts and government bond yields have been on a 30-year downward trajectory, while average property yields have remained within a range.

Source: IPF

Add to this the recent Bank of England base rate cut to 0.25 per cent and the returns in terms of yield look good for commercial property.

For example, Jonathan Wilcocks, global head of retail sales at M&G, says: “Commercial property has traditionally provided attractive returns that come from the steady long-term income that the asset class provides.

Approximately 70 per cent of the total return on property has come from the income alone.”

The £4.43bn M&G Property Portfolio, managed by Fiona Rawley, has a yield of 4.14 per cent, as at 4 August 2016.

Diversification and performance

Mr Carthew says: “Most funds invest in property directly and here part of the attraction is being in an asset class not perfectly correlated to equity markets.

“Investing in a commercial property fund gives individual investors a diversified portfolio of large properties, managed by experts in the field.

“Each sector - retail, leisure, offices, industrial - has its own drivers of supply and demand, which in turn influence their valuation. Some funds invest in a spread of different types of asset.”

Mr Lowcock adds these have an advantage over investment trusts, also: “Investors can get the absolute performance of commercial property in an open-ended fund, compared to the discount or premium to the net asset value (NAV), which they would get in an investment trust.

“Therefore, there is less volatility.”

Mr Wilcocks adds: “Commercial property funds provide clients with the opportunity to get exposure to the asset class across a well-diversified portfolio of assets in terms of geography and sector, rather than taking the direct route with far greater stock specific risk.”

Tom Dorey, head of retail product for Schroders, agrees: “Historically, an investment in commercial property has provided diversification for multi-asset investors since its correlation with equities and bonds is low.

“Property can also provide a relatively attractive yield, one factor why investor interest has picked up in the past year as bond yields continue to fall. Like residential property, commercial property also has the potential for capital growth over the long term.

“The high value of many commercial properties means that for most investors a fund which pools their investment with others is the only way to get exposure to a diversified portfolio of assets.”

Disadvantages

But liquidity, as the markets have seen over the past two months, is a huge issue for open-ended commercial property funds, especially those with daily dealing.

This is because funds with bricks and mortar holdings - such as the M&G Property Portfolio - cannot easily redeem holdings.

Some of these less liquid funds are among the largest retail funds available for UK retail investors. The below graphic shows 10 property funds of more than £1bn in size.

Mr Dorey comments: “The daily dealing funds which are available to retail investors are generally able to cope with the balance of investor in and outflows. However, there have been times when this has not been the case.

“The FCA has stated that it intends to review the structure of daily dealing funds and their appropriateness for retail investors.”

However, as QuotedData’s Mr Carthew explains, not all property funds invest in mainstream locations valued in the tens of millions or more, as there are some targeting smaller lot sizes.