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Lease of life

In my last article, I began to look at the short-term prospects for investments in the major asset classes of equities, fixed interest, cash and property. I concentrated on the commercial property market, paying particular attention to funds investing directly in property. In this article, I will conclude this part of the discussion and move on to look at funds investing in property shares.

Having already determined the attractions and potential risks of property funds, in this article I will outline a number of ways in which an adviser might select a fund which might produce competitive returns for his client. In no particular order of importance, I will look at (below):

  • Percentage of the fund invested in property
  • Average rental yield on the fund
  • Average remaining lease term
  • Typical terms of the lease
  • Quality of the tenant
  • Voids
  • Geographical diversification
  • Sector diversification

I have already highlighted the fact that most, if not all, of the funds investing directly in property currently hold a significant proportion of their assets in cash deposits. This is due to a number of important factors arising from the increasing popularity of property funds among investors and their advisers. Quite simply, fund managers have not been able to identify sufficient attractive property investment opportunities to satisfy their huge cash inflows over the last few years.

Even when opportunities have been identified, the nature of the commercial property market is such that transactions may take many weeks or months to complete. I know of three major funds whose percentage invested in cash exceeds 25 per cent, which dilutes potential returns over the short to medium term.

By way of a simple example, let us suppose that we expect a return from commercial property of, say, 8 per cent a year over the short term and 4 per cent a year from cash deposits. If a fund were invested entirely in reasonable quality commercial property, our projected returns would be 8 per cent a year. Suppose, though, that the fund had 25 per cent of its assets invested in cash. The composite projection would be (right):

Clearly, at least on the mathematical face of it, the higher the proportion of cash in a property fund, the lower must be the short-term expected returns. Against that supposition, managers of funds with relatively high cash contents could argue that their liquidity enables them to react quickly to short-term buying opportunities, for example, in recession-hit geographical areas or property sectors.

If true, this argument would suggest that relatively small reductions in annual returns over the short term will lead to advantageous capital gains over longer terms.

Moreover, higher cash contents overcome the long-held argument against property funds that restrictions may be placed on sellers in the event of a rush of investors wanting to divest themselves of their property fund holdings. These restrictions are introduced to protect fund managers from having to liquidate some of their investments at fire sale prices.

To summarise this issue, the higher the cash content in a property fund, the lower might be the expected returns – at least in the short term – but liquidity will be higher and a skillful fund management team might be able to take advantages of short-term buying opportunities.

If this sounds as if I am sitting on the fence in deciding the ideal proportion of cash I would like to see in a property fund, I certainly am. The fact of the matter is that all the leading property funds I consider recommending to clients have an historically high cash content, so I really have no choice in the matter. At the end of the day, at least I am aware of the issue and its implications in portfolio plan- ning and the projection of expected investment returns.

Moving on, I strongly suggest it is worth finding out the level of current rental income from your preferred property fund providers. I noted in my last article that property returns consist of rental income and capital gains or losses (as regularly measured by the Investment Property Databank website).

While, historically, the capital values of commercial property have fluctuated quite wildly – although not in recent years – rental income tends to be much more predictable. A fund invested in a diversified range of commercial property with long-term leases let to good quality tenants should produce a consistent level of rental income. Consistency and longer- term security of rental income tend to lead to consistency and security of longer-term capital values, almost regardless of the general state of the property market.

I noted in my last article that average rental income yields from commercial property are currently running at 6 per cent a year (source: IPD index) so it would not be unreasonable to expect a competitive property fund to be achieving yields at least at this level. However, much depends on a number of other issues, as I will now discuss.

First, though not necess- arily most important, is the average remaining lease term of the fund’s portfolio. Some of the top-performing property funds have consistently maintained an average rem- aining lease term of around 10 years. This means some of the holdings will have tenants with only, say, a year or two remaining on their tenancy agreement while others might have 20 years or more. Generally speaking, the longer the average remaining term, the longer the security of rental income, although for properties in sectors or geographical areas with high demand, the cessation of a tenancy might offer the opportunity of a significant upward rating of rental income.

Overall, I suggest that an adviser should be looking for an average remaining lease term of at least eight years – anything less and the security of s future income stream to the fund diminishes.

On, then, to the terms of the leases within the portfolio. If we assume, as I have noted above, an average rental yield of 6 per cent, we must then pay attention to provisions within the leases for rental increases. It has become generally accepted that commercial property leases include a provision that the initial level of rental income will increase every three or five years by the rate of price inflation. This means that an initial yield of 6 per cent will remain at that level relative to the price inflation-linked value of the property.

Strangely enough, such provisions contrast closely with rates of return from index-linked gilt yields, which currently stand at around 1.5 per cent. Fair enough, the security of capital from these gilts is higher than from commercial property but, looking at it another way, potential capital gains are restricted.

A quick word with the fund provider will confirm the normal provisions within their portfolio for rental increases – the higher the better, obviously.

However, this is all sub- ject to my next point, which I will develop further in my next article – the quality of the tenant.

I will use a quick example to illustrate this point in the meantime. Suppose that commercial property A has a rental income of 6 per cent a year and is let to Royal Bank of Scotland with a remaining lease term of 23 years, with a three-yearly upwards-only rent review. Commercial property B, by contrast, has a rental income of 8 per cent a year and is let to a small regional wholesale grocer with a remaining lease term of two years, with no provision for any further rent reviews. Even worse, it has become badly situated for attracting new tenants.

In which property would you want your preferred property fund to be invested? More about this point, and the remaining issues listed above in my next articles.


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