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Is property set to subside?

Brick and mortar have held up well but cracks have been appearing in funds invested in property shares, says James Phillips

The outlook for the UK commercial property market is dividing adviser opinion.

Investor confidence seems to have taken a knock after several property funds imposed bid/offer spreads in July, reflecting a slowdown of inflows. Property had been the best selling sector for 19 consecutive months until the Investment Management Association’s August sales figure showed it had slipped behind UK all companies and cautious managed.

Returns this year are below the double-digit figures between 2004-06 but it is not all doom and gloom. The IPD UK all property index is up by 4.6 per cent over the year to date although the average property fund has fallen by 5.39 per cent, according to Morningstar.

Helm Godfrey managing director Bruce Wilson says short-term performance issues should not mask the fact that property is a long-term asset that investors should hold to diversify their portfolios away from the traditional mix of equities, bonds and cash.

JS&P certified financial planner Patrick Connolly says the performance of the sector as a whole has masked the continued positive progress of bricks and mortar and most of this down to property shares.

When property share funds are stripped out of the specialist sector, comparisons between individual funds can still be difficult. The two worst performing property funds – Aberdeen property share, down by 24.58 per cent over the year to date, and Scottish Widows Investment Partnership UK real estate, down by 29.07 per cent – have undoubtedly dragged down the sector. Five other funds have also posted double-digit losses.

Connolly points out that many bricks and mortar funds also hold a portion of their portfolios in property shares to provide liquidity and this has dragged down several, including the two biggest retail property funds, the £4.2bn Norwich property and £2.1bn New Star property funds. Norwich property, with an 8 per cent weighting in property shares, is down by 6.23 per cent while New Star property, which holds around 18 per cent, is down by the same amount.

Connolly says: “We are extremely positive on property but it is important to know what you are investing in. A number of high profile property funds have fallen in value this year because of their exposure to property shares. Physical property continues to deliver an excellent income stream and remains a good diversifier.”

He only recommends the UK property funds of M&G, Legal & General, Resolution, Skandia and Scottish Widows due to their pure bricks and mortar nature and insists investors hold all five to ensure better diversification geographically and sectorally.

Not all advisers are so positive, however. Kohn Cougar managing director Roddy Kohn says he would not currently recommend UK commercial property because he believes better yields and capital growth opportunities can be found overseas.

Killik put a sell note on UK commercial property in January, saying it believes the sector is heading into a prolonged downturn.

Head of fund research Mick Gilligan says the weight of investor money piling into the market has pushed down yields to around 5 per cent in many corners of the property market, less than the 5.5 per cent cost of long-term borrowing.

He says this negative carry-trade means yields are insufficient to fund the cost of borrowing on a property, meaning it is a loss-making investment unless the asset is seeing capital growth.

Gilligan says even if interest rates come down as a result of the credit crunch, a number of problems remain for the property sector.

The City of London property market has been the key driver behind the IPD UK all property index this year. Offices comprise 35 per cent of the benchmark and are up by 8.1 per cent over the year to the end of August, helping the index to a 4.6 per cent gain. By comparison, the retail sector, down by 0.5 per cent, and industrials, up by 0.5 per cent, have lagged.

Franklin Templeton head of real estate Jack Foster says the City makes up half the office component of the benchmark and so around a fifth of the overall market.

His prime concern is that the credit crunch will result in financial institutions putting expansion plans on hold, causing a slowdown.

He says: “The office sector has been a big driver of performance over the last year and the credit crunch is impacting on the financial sector, the primary users of office space. It is a concern.”

Close Investments managing director Simon Cooke is very bearish on the UK, saying capital values on properties could fall by 20 per cent. He says transactions are already slowing.

Cooke believes that for properties to look attractive again – given that rental income will be difficult to grow when companies are tightening their belts – yields have to go up, necessitating a fall in capital values.

He says: “Yields have fallen to 5 per cent compared with historic levels of 7 per cent. This is below the five-year borrowing rate of 5.5 per cent and unsustainable. This means a 20 per cent drop in valuation is needed.”

New Star property unit trust manager Marcus Langlands Pearce says no one knows how hard the credit crunch will hit and the main impact has been a downturn in sentiment. He says: “Letting agents in the City say demand is still good and companies are not yet pulling out of their commitments.”

He admits short-term volatility is likely but there are some positives that could come out of the credit crunch, mainly that banks’ unwillingness to lend big sums could see a contraction in new developments at least for the next six to 12 months. “This will put a constraint on supply and provide added impetus to rental growth in prime office locations,” he says.

Foster insists any fall in supply will be positive and means that when the credit crunch works through the system, which could take between six to 18 months, there will be lots of attractive opportunities in the market.

The difficulty for advisers is whether to recommend property now as a long-term investment or try and time the market when better value might be emerging.


Delegate places for Fof forum filling up fast

The Money Marketing Fund of Funds Forum take place at the Merchants Taylors’ Hall in London on Thursday 18 October.The morning will feature presentations from leading fund managers on how to select the right fund of funds and how to choose the right multi-manager. Speakers include John Chatfeild-Roberts of Jupiter, Richard Skelt of Fidelity, Aidan […]

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