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Building blocks of a portfolio

After our expansion last week of the concept of achieving positive portfolio advantage (high returns with reduced overall volatility) from negative or even mildly positive correlation between different investments, we return to our look at the major asset classes this week.

Readers who have been to any of the seminars I have presented on this subject may remember that commercial property investments have been a particularly favoured portfolio asset in my opinion over the last five years and continue to remain so.

First, let us compare the investment performance and volatility of commercial property investments over the last 20 years as measured by the Investment Property Databank index – the broad equivalent of the FTSE indices for equities – with the asset classes we have already highlighted over recent weeks.

Readers who have followed this series so far will not only be able to see immediately that property investment returns have outstripped both index-linked gilts and cash over the last 20 years but also that they have concurrently suffered higher volatility (no surprise here, remembering the core concept of risk and reward).

Against long-dated fixed-interest gilts, however, property has underperformed significantly by an average of 2.5 per cent a year with no real difference in volatility. The index for two standard deviations relates more to one single year within the 20-year period under review, you may remember.

So, what are the investment features of commercial property? First, it is important to clarify that, for the ordinary investor, commercial property can only realistically be considered through collective investment funds. These benefit from a regular income in the form of rent. This will invariably be payable under a lease agreement which will tie the tenant to occupation of the property for a predetermined period. The agreement will also stipulate the dates at which a review of the rent will take place and detail how such a review is to be conducted.

A standard lease agreement will have a tenancy period of at least nine years and will specify rent reviews – sometimes stipulated as being upwards only – every three years.

The most important factors to consider when assessing the quality of a lease agreement – which is important, of course, in determining the quality of the projected future flow of income from the property – are quality of tenant, term of agreement and provision for rent reviews.

As an example of the importance and attractions of these factors, a property fund which has been a particular favourite of mine for a number of years regularly produces reports and agrees to be questioned by individual IFAs. This has shown that, for some time, the average remaining lease term of its property portfolio has been in excess of 10 years, the majority of tenants are of premium grade and a significant proportion of its rental agreements make advantageous provisions for future rent reviews.

This is by no means the only property fund with a similar combination of features, although not always to the same extent, and it therefore begs the question – what could go wrong?

Simplistically, these funds enjoy a secure income which increases each year – expected to be at least in line with increases in price inflation – with little risk to the ceasing of that income due to the quality of the tenants and lease agreements.

Think for a few seconds about an asset class we have already considered which boasts similar features to those summarised in that last sentence – index-linked gilts.

Index-linked gilts also provide a secure income which rises each year in line with, but in this case no faster than, increases in price inflation, with the security that this income is paid by the Government. The big difference between income from these two assets is the level of the income payments at the outset.

The income yield on mediumand long-dated index-linked gilts is hovering round the 2 per cent mark, yet the income yield on commercial property (as measured by the leading nationwide index of a “basket of property”) is around 7 per cent. No contest?

Of course, the income yield on index-linked gilts is only one aspect of the returns generated. The capital value also increases in line with price inflation. There again, commercial property values should also rise, at least in the medium to long-term. True, property values fell by more than 10 per cent each year in the first three years of the 1990s and fell again by 4 per cent in 1994 but, immediately before and after each of these periods, property values increased quite substantially so that, over the long term, the trend markedly continued to follow price inflation.

As regards volatility, commercial property values have increasingly been determined by the rental income they generate rather than by the notional value of their bricks and mortar. I have recently had this reconfirmed by my own portfolio within a Sipp, which is at present negotiating to buy a large property in a lovely location which is, however, little in demand for office space – fortunately for me, because that is helping to drive down the price.

If rental income and growth are secure, then the value of the property should perhaps fluctuate less than has been the case historically.

Commercial property can be considered an alternative investment to fixed-interest gilts but I would contend there is little doubt about the preferred option here. Long-term fixed-interest gilts are showing a redemption yield (that is, of course, taking income and capital growth or falls into account) of little more than 4.5 per cent, which compares unfavourably even against only the rental yield from commercial property and, therefore, excluding long-term capital growth.

If this demonstrates a little personal bias towards commercial property, then I stand justifiably accused. I accept that solid arguments can be put to the contrary. But, in each of the last four years, commercial property has shown double-digit returns with exceptionally low volatility.

Clearly, commercial property merits serious consideration for any portfolio, especially if we identify a low correlation with other investment asset classes. Next week, we will move towards the conclusion of this series of articles and start to consider equities, both UK and overseas.


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