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Commercial breakdown?

Chris Salih looks at whether commercial property is heading for a fall.

There has been a growing consensus in the past few months that the sparkling performance of commercial property will slow markedly at some point in the near future following unprecedented returns of around 18 per cent in each of the past three years.

The returns have firmly established property as the third mainstream asset class behind equities and bonds.

Traditionally a stable, defensive investment, the recent outperformance of property has not only seen it compete with equities as an asset class but has also established it as an attractive diversifier for investors.

Advisers have been ploughing money into property funds and Cofunds recently revealed that six of the top 20 funds on the platform are property vehicles. Standard Life Investments says its select property fund has broken the £1bn barrier only 15 months after its launch. But are advisers falling into the age-old trap as they start to use property as a stand-alone investment?

New Star property unit trust fund manager Marcus Langlands Pearse says performance is set to drop but it will be a market correction that will see returns revert closer to their longer-term average rather than fall off a cliff.

He says: “The one thing that we are concentrating on saying is that after a couple of years of stellar returns, we expect the asset class to return to normal and still perform above 10 per cent. It has not and has never been there to outperform equities as it has always been a bond-style investment.

“High single-digit returns between 2007 and 2010 would not be unreasonable although it would be below the expected returns over a longer period. The real issue is that investors have seen it perform as it has in the past few years and expect it to continue.”

Thinc Group investment director Ian Shipway says there is a trap for advisers but the sector is ideal as part of a diversified portfolio as there is an embedded income stream that comes with property.

He says: “In terms of performance, we have seen a period where yields have come down by 1 per cent or 2 per cent. If I were asked to compare property with equities, I would favour equities every time.”

Scottish Widows Investment Partnership property research manager Stuart Low says that although prices are rising and yields are falling, there is little cause for concern.

He says: “Many forecast that yields will continue to fall below the 10 per cent barrier and we are not disagreeing but we feel they will edge up on the retail and rental side a bit earlier than expected.

“Rents are currently at the rate of inflation, with 2.8 per cent growth on offices. Retail continues to be poor within high-street and in-town shopping centres as there is a modest rate of consumer spending due to rising interest and mortgage rates, meaning slightly less money in the market.”

Low says that in the current climate, investors are better off staying in the sector because of the defensive high yield. However, for those not invested, this may not be the best time to test the waters.

He says: “Property no longer works in isolation, with yields now correlated with other external factors, such as swaps and borrow-ing, while rental growth is nowhere near strong enough to justify yields where they currently are.

“Fortunately, investors are relatively sophisticated and know not to expect returns in the region of 18 per cent again. This year, we expect a return of 5.1 per cent, which is 2-3 per cent after inflation. Traditionally, it would be 4 or 5 per cent.”

Hargreaves Lansdown head of research Mark Dampier is one of the biggest critics of the weight of money being thrown into property funds although he admits he has missed the boat in the last three years he believes property is set for a fallback.

He says: “It is bricks and mortar and so is an illiquid market and investing 50 per cent of a client’s money is just too high. I would place a maximum of 10-15 per cent into property as it has been oversold and bigger accounts need to take profits out now. Having 30-40 per cent of a portfolio’s asset allocation in property would not be unheard of.

“Buying an asset as a diversifier only works if that asset is cheap. Commercial property is not and has not been for some time. Rental yields have been 4.5 per cent while gilts have operated 4.75 per cent, meaning there is little or no value. UK commercial property is overpriced compared with overseas, where there is some value still to be found. The problem remains that people have chased yield while it has remained high.”

Dampier also believes that the introduction of real estate investment trusts will have little impact as they have come too late in the UK to catch the commercial property boom. This is in spite of nearly half of advisers planning to use them, according to research carried out by consultantcy NMG Research.

He says: “When Reits were introduced in Japan, they had in the region of a 5 per cent yield, with a 0.2 per cent deposit. In the UK, deposits are at 5 per cent while yields are hovering around 2.5-3 per cent. Where is the value in that?

“Property is already a mature market with little or no value in terms of

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