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Brian Tora: Time to take commercial property warning signs seriously?

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After hardly featuring in my postbag for some time, suddenly property is cropping up all over the place. I am talking commercial property here: an asset class that has delivered handsomely recently. Quite why it is attracting attention is hard to gauge. One email canvassed my opinion on its attractions as an asset class, given the low level of returns available elsewhere. Other comment has been less favourable.

Once, commercial property was hard to access unless you were seriously wealthy. Today, the options to climb on board are many and varied. As well as closed-ended funds, there are now a number of open-ended vehicles that provide investors with an easy route in. Life companies, themselves large investors in commercial property, are active in this sector, with Aviva, Legal & General and Standard Life all with funds on offer.

Perhaps this is where the problem lies. Cashflows into an open-ended fund give the manager money to invest. This in turn can push the asset price higher. In the case of commercial property, the supply is more restricted than in many other cases and several fund managers bidding for property assets at the same time will certainly distort the market. Since commercial property is subject to cycles, it is worth trying to judge when a turn might be in prospect.

In the closed-ended field, investor demand for the shares of investment trusts devoted to the property market has often driven them to a premium over the value of the underlying assets. This is understandable, given the difficulty of investing in commercial property direct but current premium levels look little less than crazy. The average premium for the property direct sector, taken from the Association of Investment Companies statistics, was 11.2 per cent at the time of writing.

Taking one of this sector’s crop, F&C Commercial Property, the premium is a whopping 22 per cent. Just under a year ago I remember reading an article in the personal finance pages of one of our more conservative broadsheets extolling the attractions of the sector and mentioning the F&C trust – which was, and still is, highly regarded – which then stood at a premium of 15 per cent. It seems investors seeking income have been responsible for pouring money into fund managers pockets and driving the prices of listed vehicles higher.

So what happens if the cycle turns down? The consequences could be quite dramatic, with open-ended fund managers turning sellers of prime property and premiums on investment trust shares evaporating. Of course, nobody knows quite when this might happen and the domestic economy at least looks to be bubbling along quite nicely. A hiccup in our economic growth or a rise in interest rates occasioned by inflation turning up or the economy racing away could produce a different scenario.

In the US, long bond yields are beginning to tick up in anticipation of the Fed starting to tighten and raise rates. At an analysts presentation following one of our leading property companies’ results recently, the chief executive of said company predicted the cycle would turn down, perhaps in a couple of years time but sufficiently soon for him to be planning to position his company’s property portfolio accordingly.

So it seems the warning signs are there. Could this be a false alarm? Of course it could. There is no sign of interest rates rising here, while even chief executives can make misjudgements. Nothing in the investment business is ever certain but I worry the sort of premiums we are seeing among property investment trusts are simply unsustainable, while the growth of open-ended funds investing in commercial property has introduced a new dimension in to the dynamics of the sector. Care in the future seems called for.

Brian Tora is an associate with investment managers, JM Finn & Co.

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