The asset class does not receive as much attention as bonds and equities but an allocation to property could be an option for any investor looking to construct a diversified income-generating portfolio.
There are two main types of commercial property funds. The first and typically the most popular, are direct property funds which buy commercial real estate such as industrial and retail parks as well as office blocks. The aim is that the rent from these properties should provide a steady income for investors, who can also potentially benefit from any capital appreciation.
Money invested in this type of fund is spread across a range of different properties, which helps with diversification and ensures that if one or more properties are unoccupied for a period of time, the others can still generate income.
The second style is indirect property funds which invest in the shares of forms that operate in the property and property development sector. As a result, their performance tends to be much more linked to the wider equity market.
How has the sector compared to other asset classes in volatile market conditions?
The main attraction of property funds is not only that they can potentially provide a good source of income, but also that they can offer investors an extra layer of diversification in a volatile market environment. Commercial property has historically displayed low correlation to other asset classes such as equities and bonds. As a result, property tends to perform differently to other investments in response to different market conditions.
How are property funds structured?
Property funds can either be open-ended, such as unit trusts or open-ended investment companies (OEICs), or they can be closed-ended, such as property trusts or real estate investment trusts (REITs).
Close-ended vehicles like investment trusts are stock market listed and are traded in the same way as shares. They don't face the same liquidity issues that their open-ended counter parts have to deal with where physical property will need to be sold to meet investor withdrawals if insufficient cash is available.
What are the risks?
There are two significant risks associated with property funds:-
A lack of liquidity
While most property funds will hold a proportion of the funds as cash to meet investor redemptions, when a very large number of investors decide they want to cash in, serious problems can arise - we saw this during the financial crisis of 2008 and following the BREXIT referendum. Basically, managers that did not have an adequate cash buffer in place had to sell properties to reimburse exiting investors which is a long and drawn out process.
On both occasions, a number of open-ended funds had to be suspended because too many investors moved to cash in their holdings at the same time. Under such circumstances, investors can not do anything and need to stay put until the suspension is lifted. Investors in suspended funds do however, continue to receive income from the portfolio.
Property funds can also introduce what is referred to as 'fair value pricing' which can deter redeeming investors. This means a fund manager makes adjustments to the value of their assets based on their estimates of the current likely values of the fund's property holdings if it had to be sold a short notice. The 'fairer' dealing price takes account of the fact that properties coming to the market may not achieve recent valuations. The primary aim of this to prevent sellers from receiving too high a value for theri shares, which would impact long-term investors in the fund. It also means that when investors want to cash in their investments, fund managers are not forced to sell the buildings they invest in at short notice, which could mean they are unable to get as high a price as they would if they were able to wait.
For investors stuck in suspended funds, even when the restriction is lifted they could find that a fair value pricing has been applied and they will need to decide whether or not they want to sell their holdings at a discount.
As the shares in close-ended funds, such as property trusts and REITs are listed and traded like stocks, they don't face the the same liquidity issues that open-ended funds have to deal with. Investors can sell their holdings more easily - if they want they simply sell their shares.
Despite the risks involved, commercial property is still generally viewed as a good diversifier, but investors need to be comfortable with the risks involved. The sector as whole endured a very difficult 2016 following the BREXIT referendum and a number of funds were suspended in July that year all of which have now been lifted. Fund managers are starting to see net inflows and large stockpiles of cash are building up ready to be deployed.
For more information on the funds available in this sector to invest into for your ISA, Juniors ISA, Investment Account or Pension Account, please call the office and we will happy to provide the information you need.
All information in this article was accurate at the date of the original publication in June 2018.