UK Commercial property – is it the time to jump back in?

Posted On Monday, 12 May 2008 02:00 Published by
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Experts are divided over what has been a big earner in recent years – until the credit crunch. Some see it rebounding while others are more cautious

If there were an award for the most spectacular fall from investment grace over the past 12 months, the commercial property sector would be a strong favourite. But does that mean investors need to stay clear of the market, or is it time to give it another chance?

Just a year ago, commercial property still had the flavour-of-the-month taste about it after more than a decade of eyecatching growth. Over the past five years the average fund investing in UK commercial property – such as offices, retail premises and industrial units – has grown by more than 60 per cent, with some funds returning almost 100 per cent for investors over that time.

Private investors ploughed some £5 billion into the sector in 2006 and early 2007, before rising interest rates pushed borrowing costs over rental yields and the credit crunch arrived to help burst the bubble. As of early May, the sector average stood at -18.3 per cent.

As investors deserted commercial property funds in the face of plunging returns, several providers resorted to blocking withdrawals to prevent liquidity problems, to the extent that an estimated £8bn of investors' money is currently locked into them. Other providers, including New Star and Standard Life, introduced exit charges of between 4 and 7 per cent as early as last July.

Now, however, there's a conflict of opinion as to where the sector is heading. Just as some experts declared the worst was over, the Bank of England set new alarm bells ringing by warning that banks could face significant losses after continuing to pile into commercial property despite falling prices. On top of that, some estate agents believe a double dip – a second correction – is possible.

With a 4.2 per cent capital values correction in December slowing to 1.3 per cent by March, indications are that the pace of the slump has eased, while it seems the flood of fund withdrawals has already slowed, if partly because of the lock-ins imposed. The Investment Management Association reported a net inflow for commercial property funds in March for the first time since September, with £21 million of private investment compared to a net outflow of £7m in February.

According to Juliet Schooling, head of investment research at broker Chelsea Financial Services, commercial property is starting to look attractive again. "It's better value than it's been for a long time because the difficulties the market has been through are priced in," Schooling said.

Andrew Wilson, head of investments at IFA Towry Law, is similarly optimistic. "While it depends a lot on the next leg of the UK economy, commercial property appears to have bottomed out. The pace of decline has slowed and we're starting to see net fund inflows, while yields are more positive as well."

Others remain more circumspect. Alan Steel, chairman of Alan Steel Asset Management, is an advocate of contratian investing and believes there's a lot of investment cash waiting to get back into commercial property. But he also believes the market has yet to reach its lowest point. "At some point in the next year there will be good value in commercial property funds, but it hasn't quite bottomed out."

Gavin Haynes, investments director at Whitechurch Securities, concurred, insisting that, while yields are starting to look more attractive, there's more pain to come in the UK commercial property sector. "The fundamentals are not strong enough in the current climate and it's an economically sensitive area," he explained. "In the office sector there's too much supply and too little demand, while the consumer spending fall means the retail sector has slowed."

One problem faced by investors, advisers and fund houses is that the inflated returns of recent years raised investor expectations to unrealistic levels. Ostensibly, commercial property funds investing in bricks and mortar – rather than in property shares – are an income producing diversification play, a way of reducing volatility due to a low correlation with equities and bonds.

"Commercial property should be a core position in a diversified portfolio," said Barry MacLennan, investment director at Standard Life Investments. "But 14 years of stellar returns up to 2007, followed by a correction, means managing expectations is key because shooting the lights out is not what this asset class is about. In reality, investors should expect annualised returns of around 7 and 8 per cent from commercial property."

Wilson argued that investors seeking diversification should have commercial property exposure regardless of prevailing market conditions, pointing out that, while investors using commercial property as a core diversifying asset class won't suffer over the long term, those attempting to time the market would. "If you're in a pension property fund you will have made 7.5 per cent compound a year over the last five years, still well ahead of cash," he said. "It's a fantastic diversifier. Because it has a very low correlation with emerging markets, for example, it allows you to go more into that area elsewhere in your portfolio."

Of the funds investing in bricks and mortar, Wilson picked out the Legal & General UK Property Trust, which by focusing on smaller properties has not been so badly hit by the prime property slowdown over the past year. Haynes singled out the M&G Property Portfolio, adding that some property share funds – as opposed to bricks and mortar funds – are currently benefiting from significant discounts in their underlying assets. This point was supported by Laurie Petar, manager of the Jupiter Fund of Investment Trusts, who said: "While I am not actively looking to build a significant position in commercial property, I have picked up one or two opportunities recently where the discounts and yields have looked particularly attractive."

But, according to MacLennan at Standard Life, while it's not a good time to jump in with both feet, investors with access to an adviser who can look closely at the type of property in which funds are invested could reconsider the sector. With the fortunes of various commercial property sectors varying significantly, most fund managers are taking aggressive overweight and underweight positions in different parts of the market.

"We're favouring retail exposure at the moment but with an emphasis on regional shopping centres," MacLennan explained. "Consumer spending has tightened so we're avoiding out-of-town retail parks and focusing on smaller, high-quality facilities where there's little competition."

Investors seeking added diversification can invest in funds offering global exposure. Growth in the Far East and boom areas such as Dubai have lured thousands of investors over the past 18 months, while European property funds have also proved fairly popular.

"As an asset class, commercial property should not be ignored, but in the short term the UK is not rewarding and there are more attractive opportunities overseas," according to Gavin Haynes. He recommends the New Star International Property fund, as a large cash element means it is more cautiously positioned than some of its counterparts.

However, continental Europe is also beginning to experience the same problems that afflicted the UK commercial property market, and MacLennan warns that, while overseas exposure means a wider spread of risk, it can also be more volatile. "If you've got a core of UK commercial property, a fund offering global exposure can enhance that. But in areas such as Asia especially the volatility is higher and exposure should be limited."

Publisher: The Scotsman

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