How far can the commercial property rebound go?

Traditional investment wisdom has long viewed commercial property as a key element of a well-diversified portfolio - much less volatile than equities, largely unaffected by the ups and downs of the stockmarkets, and ideal for investors looking for a reliable income stream with steady capital growth.
The past two and a half years, however, have knocked those assumptions for six: having enjoyed a five-year capital growth rally of more than 50% to July 2007, the UK commercial property market fell by 45% over the next 25 months.

The run by investors on some funds, including offerings from Norwich Union, New Star and Standard Life, was enough to force them to close their doors to redemptions.

A year ago, only the hardiest bargain-hunters were following the stony commercial property trail. But a year can be a long time as far as market fortunes are concerned.

The massive fall in property values pushed all-important rental yields  - rental income expressed as a percentage of capital value - way above long-term average levels.

As a result, property became an increasingly attractive proposition compared with other sources of income.

As a consequence of the impressive yields available, last July saw investors starting to return to the market and capital values beginning to rise again, and that trend has strengthened steadily since.

The latest Investment Property Databank figures show record-breaking capital growth of 7.4% for the last quarter of 2009.

Capital growth has been further fuelled in part by a lack of supply, as the flow of developments pretty well dried up with the collapse of the market.

"Banks have also been reluctant to sell repossessed assets at the bottom of the market," reports Ainslie McLennan, co-manager of the New Star UK Property fund.
Is enthusiasm justified?

The autumn turnabout in property valuations was picked up on in a big way by canny investors.

Property funds were the best-selling retail fund sector in both October and November 2009 (the most recent months for which statistics have been released), according to the Investment Management Association.

But is their enthusiasm justified, looking ahead to another very uncertain year?

It seems so. Improving valuations have led to some tightening of rental yields, but they remain very competitive.

"Yields are currently averaging around 6% to 7%, but that is somewhat misleading as a long-term trend because prices have fallen so much; a more typical property fund yield average would be around 4% to 5%," suggests Justin Modray, director of the financial website

However, Sheridan Admans, investment adviser at The Share Centre, adds that although yields are relatively high, they "are not likely to come down excessively in the near future".

Moreover, although capital values have recovered by maybe 10%, they remain a third lower than the July 2007 peak.

Direct and indirect ways to get into property

There are two main routes into commercial property for Isa investors looking for a piece of the action.

Some funds, for instance M&G Property Portfolio and SWIP Property Trust, are directly invested in bricks and mortar - typically, 70% to 80% of the fund will be in physical assets, with the balance in cash and shares to provide the necessary liquidity should there be a run on the fund, although these funds are more illiquid compared with, for example, investing in property companies.

Modray, however, points to the positives: "First, they provide genuine asset diversification for your portfolio because they are not focusing on equities, and second, they tend to produce a more consistent and higher income than indirect funds."

The alternative route is the indirect one, via a fund such as Aberdeen Property Share. Indirect property funds invest in a portfolio of shares in listed property companies and real estate investment trusts (REITs), which in turn invest in physical properties.

The funds may be subject to stockmarket volatility because they hold actual equities.

On the other hand, there is arguably potential for higher returns from these funds because they benefit from short-term stockmarket sentiment as well as that of the property market, and also because property companies can gear up to boost their investment exposure. 

Another ISA option is a global or UK ETF (iShares offers some). These also track property companies and REITs rather than physical property prices.

Alan Dick, managing director of Forty Two Wealth Management, favours them over bricks and mortar because of their cheapness and liquidity, and the transparency of their pricing.

"I'm wary of anything based on assessed valuations - someone's guesswork - rather than traded market valuations," he explains.


If you hold a self-select ISA, you also have the option of investing directly in these property companies or REITs. The advantage of REITs versus conventional property companies is the tax treatment of income payments.
So what's the best bet for your ISA? In the current conditions, most advisers are in favour of bricks and mortar funds. First, says Modray: "Investors are going into property for income and/or diversification, and physical property is a better bet in those respects."

Moreover, says Admans, indirect funds are risky at the moment. "Property company share values have moved up with the stockmarket bull run and there's a real risk that they are trading at a premium to their net asset values; certainly they're already fairly valued.

"That leaves investors particularly vulnerable if the stockmarket suffers a double dip."
Of course, not all direct property funds are focused on the same type or quality of commercial property.

In the current wobbly economic climate most commentators recommend looking for funds concentrating on prime properties, with top-quality, recession-resistant tenants on long leases.
Adrian Lowcock, senior investment adviser at Bestinvest, also stresses the need to look at the amount of cash being held.

"Some funds have seen large sums coming in from investors, but it takes some time to invest that money in properties, and in the meantime the cash drag is diluting returns on the invested portfolio," he explains.
The New Star UK offering, with around 85% prime holdings, an average lease length of almost 11 years, low vacancy rates and a yield of 7.6%, is recommended by Lowcock and Modray.

Finally, don't go over the top with property. Lowcock suggests allocating a maximum 10% of your portfolio; Modray says 5% to 10%, although up to 20% might suit a cautious income-seeker.

The pros and cons of investing globally

Although overseas property funds have performed strongly, there's little enthusiasm for them.

First, most hold property securities rather than bricks and mortar. Second, says Martin Bamford, managing director of IFA firm Informed Choice: "There's a currency risk to build in, and potentially also other risks - political instability, natural disasters, corruption."

Third, says Lowcock, the UK is attractive, as sterling is weak and prices are very low.
However, Lowcock adds that a global fund may be "worth considering" as a spicy addition for investors with larger portfolios who already have a UK property holding, and recommends Schroder Global Property Securities.

Alternatively, suggests Modray, global property ETFs are a cheap way to access international property - "but you need to understand you're buying equity market exposure as well as property".

Investment trusts are another possibility. UK property investment trust discounts narrowed markedly last year as sentiment swung around (from 50% in January to an average premium of 11% in December), but that recovery has not taken hold elsewhere.

Charles Cade, head of research at Numis Securities, says European and emerging markets property trusts should feel the benefit in 2010 as a result of debt renegotiations, economic recovery and shareholder activism. He picks Invista European and Raven Russia as good bets.

This article was originally published in Money Observer - Moneywise's sister publication - in March 2010