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Berrington Fund Management chief executive Richard Burrell guides advisers through the commercial property fund maze

It has been difficult to get access to the commercial property sector but listed property funds could be an ideal solution for small investors..

The most significant development has been the launch of listed property investment funds, typically tax-efficient Guernsey-listed vehicles, offering a high annual dividend yield of around 6 per cent.

These vehicles solve most of the problems for small investors, who have effectively been barred by lack of liquidity, as it can take months to buy and sell a property, and the difficulty of getting exposure to assets which cost millions of pounds each.

But for advisers, it is hard to differentiate between these funds. In a booming market, most funds have performed well but they lack long-term track records, making it difficult to choose.

The majority of listed property funds benchmark themselves against the Investment Property Databank UK Annual index, the leading national commercial property index. This returned 10.9 per cent in 2003 and 18.3 per cent last year. This year, the index is expected to return around 13 per cent and the picture looks rosy in the longer term, with average returns of 9 per cent predicted for the next five years in a survey of industry experts carried out by the Investment Property Forum.

The indices are primarily of use to fund managers to compare between themselves but what the smaller investor wants to know is, how is my investment (not my sector index) going to perform against cash, equities and bonds and will the fund manager hit their adver- tised returns?

In differentiating between funds, one factor which has become more and more important is a fund’s income shortfall. Taking the fund’s rental income and deducting dividend payments, the costs of running the fund and the cost of servicing bank debt usually gives you a negative number. This should not come as a surprise – the net initial yield of the average UK commercial property (the IPD index) is around 5.5 per cent, making it hard for fund managers to meet a 6 per cent dividend target.

What has saved most funds over the past two or three years is the strong capital growth in UK property. Fund managers have been able to use the increase in value of their portfolios to partly pay dividends and mask the shortfall in income returns. But capital growth is expected to slow from 2004’s double-digit figure to an average of around 3 per cent over the next five years.

You should look out for the number of ways that smarter managers increase the income return. For example, a fund might have an opportunistic element, where 10 per cent of the assets require income and value-enhancing refurbishment or tenant restructuring. It might invest in a specialist part of the property market such as property let to government bodies. These tend to produce very secure long-term income and a higher income yield to “standard” commercial properties.

Of course, judicious use of debt will boost returns but bear in mind that above 50-60 per cent gearing, a fund’s risk profile is less suited to the retail investor.

Look out for managers who have secured debt at the lowest cost. The lower the income shortfall, the better and safer option a fund is, otherwise the fund runs the risk that, if the property market becomes weaker and capital growth flattens or even turns negative, it could be unable to make up the income shortfall with capital growth, resulting in the all-important dividend being cut.

It is difficult for an adviser who is not a property specialist to analyse the assets that a fund owns and to advise clients on that basis but there are a number of property factors which can be analysed without the need to be a property expert.

Examine the diversity of a portfolio. It is easy to see that a 100m fund invested in 20 properties offers better diversification and risk amelioration than a 100m fund which owns only four properties. The tenant base needs to be diverse as well. A 20-asset portfolio is not much use as a diversifier if all the assets are let to one or two tenants.

Alignment of interest is clearly significant as it is not just important to know how much the fund management company has invested in the fund but how much the individuals running the fund have invested.

It is also worth noting that several big life insurance firms have launched property funds recently, often seeding them with their own stock. This can have two possible risks. First, the stock is low-grade properties which could not be sold to specialist property investors. Some fund sponsors have retained massive stakes in the fund, which could cause trouble for investors if they ever want to dump stock or to buy it back on the cheap.

In addition, the UK market has seen tremendous capital growth over the past two years. This will inevitably slow down and managers will need to work harder to get returns, especially as rising capital values have brought down property yields. Development is one way to boost returns. It is the way that most of the big quoted property companies and entrepreneurs have made their fortunes but a great many of them have lost fortunes as well. Development is a high- risk business.

This is neither a good thing nor a bad thing and a small percentage of development stock (say, 10 per cent of the portfolio by value) could boost returns for little risk. Having 50 per cent of the portfolio in development makes the fund’s risk profile unsuitable for smaller investors. Make sure that, even if a fund has only 10 per cent in development, it does not have the option to change tack and increase this to 40 per cent without consulting investors.

Finally, it is worth looking at what sort of place property should take in a private investor’s portfolio. A classic asset allocation would be 40 per cent equities, 40 per cent bonds, 10 per cent cash, and 10 per cent other (including property). Most corporate pension funds have 5-10 per cent in property although asset/liability models often recommend a much higher weighting. In recent years, UK institutions have been heading for the top end of that weighting and many European funds have more than 10 per cent in property. Several recent research reports by investment banks recommend a 15 per cent property weighting.

However, for private investors, I would recom-mend having as much as 30 per cent in property. This will boost returns in comparison with bonds and boost stability in comparison with equities and give investors the advantage of that steady high income yield.

For the small investor, for whom security is paramount, the advantage of property over equities or bonds is easy to illustrate with a worst-case scenario. At the end of the dotcom boom, investors who had bought shares in dotcom firms were left with nothing when the firms went bust. Furthermore, they had nothing to show for their investment as the shares had paid little or no dividend.

Investors in property occupied by dotcoms were at least left with the property which had residual value when empty and the potential to re-let. They also had the income from rental payments already made. The security of asset-backed investments always leaves investors with something.

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