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In my latest series of articles, I will be look- ing at the current state of investment markets, covering the main asset classes used in portfolio construction – cash, fixed interest, property (direct investment and property shares) and equities.

For each of these asset classes, I will discuss rec- ent performance, current yields and growth poten- tial, recent and anticipated volatility and, perhaps most important, its potential uses in typical portfolios.

I will start with an asset class which attendees at my seminars and regular readers of this column will be aware is one of my long-time favourites – commercial property.

Just over five years ago, I had the privilege to meet a number of fund managers, who provided me with their opinions on future returns from commercial property funds (although I had not fully appreciated that all these funds were directly invested in property, rather than property shares). Rental yields were high compared with income streams from other asset classes, average remaining rental terms within some of the better funds were attractively long (an average of 10 years, indicating relative security of the future income stream) and demand for commercial property was high and expected to remain so for the foreseeable future, indicating a potential for capital growth.

Sure enough, returns on these funds have not been disappointing. Some of the best-performing pension funds have returned around 60 per cent over five years (taken to mid-year, to ensure these statistics are up to date).

Well called, it might be tempting to suggest. However, in fairness, most of that growth has occurred over the past three years. So, let us now have a closer look at more recent past performance, differentiating between funds invested direc- tly in property and those invested in property shares.

In 2004, a typical second-quartile performer produced returns around the 12 to 13 per cent mark, with top-quartile funds returning upwards from the late teens. Quite a number of funds had returns above 20 per cent and one above 30 per cent.

It is noticeable that the top-performing property funds in 2004 were typically invested in property shares, which tend to follow the general trend in equity markets as much as the trend in property values. In any event, these were admirable returns, which would add value to most portfolios seeking diversification to reduce portfolio risk.

In the past year (mid- year to mid-year), returns have generally improved further, with a significant number of funds producing 20 per cent or more.

To bring these statistics up to date, I will mention a trem- endous website – that of the Investment Property Databank ( This is a free site (unless very detailed information is required) which provides statistics on rental income and capital growth from commer- cial property. Unless someone can advise me of an even better measure, it is widely accepted as the definitive guide to these values (much as the FTSE is accepted for equities) and measures returns from around 10 per cent of the entire property market.

There is a month or so time delay in correlating this information, so the latest data I have to hand relates to monthly periods during 2005 up to the end of June.

At the start of the year, monthly returns showed a decline from 2004, when total returns from commercial property were a little under 20 per cent. The first three months of 2005 indicated average returns of just under 1 per cent a month – still decent, but the worry for property fund investors was that this fall could represent the start of a downward trend. However, this has proved not to be the case, as monthly returns from April to June were 1.31, 1.44 and 1.68 per cent respectively. Thus, the annualised rate of return remains excellent.

Now, some hints and warnings. Just as the first few months of this year could have indicated a downward trend in returns, but did not, so the last few months might indicate a reversion to an upward trend. But, then again, they might not.

I would strongly suggest that advisers do not suggest to their clients that returns from the first half of the year will be repeated in the second half. I feel that a monthly visit to the IPD website would be advisable to investigate the latest returns and how these compare with previous trends. This will give advisers an early warning of when returns from directly-invested property funds might be turning upwards or downwards, and why.

Second, the IPD index divides returns between income and capital growth. One might expect income yields to remain relatively stable over the short to medium term, which, indeed, they have. There has been little change this year from a monthly average of 0.5 per cent, indicating annualised rental yields of around 6 per cent. This compares with a rental yield during 2004 of a little under 7 per cent, so we have seen a slight reduction, caused mainly by rental yields appearing to fall when expressed as a percentage of rising capital values.

With total property returns over the past few months aver- aging around 1.5 per cent and income returns representing 0.5 per cent of this, it is clear that the bulk of returns from commercial property in the past couple of years have been in the form of capital growth.

So now we can make some predictions about the recent and current volatility of this asset class, noting again that I am only discussing funds invested directly in property (I will deal with property shares later).

In current market conditions – and those for the foreseeable short-term future – these funds should benefit from a fairly consistent rental yield of 6 per cent a year, with very low volatility of these returns. The volatility is introduced mostly by far less predictable capi- tal growth or, indeed, possible future capital loss.

In recent years, property values have been helped by demand from buyers, not least (perhaps a little perversely) including the property funds into which advisers are directing increasing amounts of client money. Thus, to some extent, we are responsible for the profits being made by our clients’ investments.

More seriously, the possible future volatility of property capital values should not be underestimated (although perhaps not over-exaggerated, either) and it should by no means be assumed that the 15 per cent-plus annualised returns of recent years will continue to be repeated. Nonetheless, with the help of the IPD website, we can confirm that conditions for these property funds remains favourable.

Third, a number of the more successful directly-invested property funds are continuing to report difficulty in quickly investing the increasing influx of client funds in attractive property propositions. Supply is not matching demand and much of the supply is in new-build projects which might not even be completed, let alone let to tenants. Thus, in some cases, a significant proportion of money remains on deposit, earning a far lower yield than property rental income, while missing the potential for capital growth.

Could I suggest that advisers in this market should ascertain the asset mix of pension funds under their consideration and make full use of the information source I have noted above.

In my next article, I will conclude this look at property funds, discussing in more depth those funds invested in property shares.


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