The asset class has enjoyed a strong period of outperformance over equities and bonds in the past decade and, while it remains a strong asset class, many investors do not know enough about the risks involved
Howard Davies, chairman of the Financial Services Authority, has warned that retail investors may be failing to understand the risks associated with investing in commercial property.
The asset class has been enjoying a sustained period of strong performance, outperforming equities and bonds over 10 years to the end of 2002. So it is not surprising private investors are turning to commercial property as a source of diversification, perceiving it as a safe haven in a continuing equity bear market.
In 2002, the IPD Monthly Index recorded property returning 10.5% (income and capital), a healthy real return. However, returns are decelerating ' rental growth is now flat across the market, with some sub-sectors, notably London and Southeast offices, showing marked falls in rental values in response to the contraction in finance and business services. At the same time, yields have been falling as interest rates have been reduced, leading to increased capital values for properties that are readily financeable and have bond-like qualities.
Over time, one of the principal drivers for property performance is rental growth, the movement of which is closely correlated to growth in the overall economy. Analysis shows there is a well-defined timelag of around 15 months between GDP growth and property rental growth. Given the slowdown in the economy, it is not surprising average rental growth is now static.
The issue for property, as with other asset classes, is to assess the potential impact on the UK economy of the geopolitical situation in the Middle East.
Gordon Brown's GDP forecast for the next three years has been widely criticised as overly optimistic. The consensus of independent forecasters suggests the UK economy will grow at around 2% this year, only marginally below its long-term trend. One of the key determinants, however, will be the effect on global growth of events in the Middle East.
Many risks remain unquantifiable. In comparison to other asset classes, though, property has features that make it better able to withstand the impact of unexpected economic outcomes.
On diversification grounds, there is a strong case for property, reinforced by the average income yield, presently around 7%.
This makes it comfortably the highest-yielding asset class. Even without rental growth in the short term, property has the ability to deliver a real return considerably above its long-term average.
The issue for investors is how to access the asset class. Many people's experience will relate to the residential market, with previous investment experience limited solely to bonds and equities.
There are different ways for investors looking to buy into property to assess risk. One is to look at the number of assets held to determine the level of diversification. Research shows that to diversify away stock-specific risk in a portfolio, some 15 assets or more need to be held.
There are a number of single building offerings that have been sold to retail investors within the past two years. It would be possible for an individual to invest in 15 or so of these vehicles but this would rarely be practical.
Most single building offerings have been in the office sector. Even a prudent investor wishing to buy into a number of these vehicles will be unlikely to gain a spread of retail office and industrial property throughout the country.
Clearly, buying just one or two of these vehicles may represent a highly risky position. What might be regarded as secure covenants may prove to be otherwise, as the spectacular collapse of Enron showed.
While properties let to the UK Government are the most secure, there is no guarantee projected returns will be achieved. Downward movements in rental values, particularly in London, may make the assumptions upon which any projections are based wholly unrealistic.
The level of debt in a portfolio is another important factor when taking on a property investment. With average property yields around 7% and the base rate now at 3.75%, conditions exist to enhance the return on equity through the prudent use of borrowing.
In a rising market, gearing can be used to produce attractive returns. However, the converse also applies. A number of property schemes offered to retail investors have included gearing of 80% to 85% loan to value. In such situations, it will not require much adverse yield shift or fall in rental value for the investor's equity to be eradicated. Investors need to understand the risks associated with the application of debt.
In selecting a property vehicle, investors should also look hard at the quality of the underlying asset base and the degree to which it is diversified. Does the portfolio contain retail, industrial and office properties?
The overall quality and longevity of the income stream are key issues, together with the geographic and sector weightings. Offices, more than retail and warehouse property, are vulnerable to depreciation, while offices in London and the Southeast are currently experiencing rental value declines. In general, these are not yet a counter-cyclical buying opportunity.
The asset base of some funds may also have been derived from the sponsoring company. Investors need to look at how the properties have been selected and how the transfer values have been attributed.
The ability for an investor to sell his investment in a limited partnership or unit trust needs careful analysis. Property is an asset class that needs to be held for one economic and rent review cycle which, for practical purposes, means five years or more. Given the entry costs for property, with stamp duty payable at 4% on all transactions over £500,000, the ability to make a good return on investment in a 12 or 15-month period will be limited.
The redemption provisions under a number of the vehicles may mean that a proportion of the funds is not invested in property and some 10% to 15% may be held in cash or gilts to meet redemptions. This may dilute returns, as will large volumes of new subscriptions held in cash pending investment.
Most unit trusts also contain restrictions on dealing when more than 10% of unit holders redeem at any one time. Property is not a liquid asset class and investors need to give due regard to this. The price of liquidity may be a discount to NAV or a large bid-offer spread in pricing.
Where the manager or promoter of the property scheme is co-investing in it, investors can take comfort that the manager's interest is aligned with their own. Such co-investment should obviously be of a meaningful amount in the context of the overall fund.
The charging structure of property funds is a hot topic when generous, 3% to 5% commissions and ongoing trail fees are offered. Too often, the commercial attraction of a fund lies in the fees rather than the underlying quality of the property fund itself.
It is clearly the FSA's belief that private investors are making property investment decisions without being informed of the potential pitfalls and associated risks. However, further regulation should not be required. What is needed is more education about the asset class, which is set to form a much larger component of an individual's investment portfolio in future.
Property has performed well recently but there are risks attached to the state of the economy and geopolitical events.
Property investments normally need to be held long term, liquidity is often limited.
Investors in property need to be aware of the level of diversification they are taking on.
Paul Bruns and Elaine Parkes
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