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When Property investments go pear-shaped

In this series of articles, I am looking at the main asset classes with regard to their recent, present and short-term future investment returns and volatility. I am also highlighting the use of the various asset classes in different client portfolios.

In my first couple of articles, I concentrated on the commercial property market, looking first at those funds which invest directly in property rather than in shares in listed property companies. Here, I will conclude my examination of commercial property before moving on to the other major asset classes of cash, fixed interest and equities.

I have already discussed the importance of the quality of leases when investing in commercial property funds. To recap briefly, the average rental yield is obviously of vital interest as this gives a good indication of the long-term income stream of the fund, especially where the average remaining lease term is relatively long (more than eight years or so). But these factors could be overshadowed if the quality of the tenants or longer-term marketability of the properties is poor.

In my last article, I gave the example of commercial property A, which 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 upward-only rent review. Here, the rental income appears reasonable in current market conditions and the quality of the tenant is extremely high, as is the remaining lease term. The triennial upward-only rent reviews are also very valuable.

Not only will this property be valuable within a fund for its future income stream but its capital value is very high as potential buyers will clearly be attracted by the likelihood that the tenant will remain solvent for at least the remaining term of the lease and therefore be able to meet the cost of the increasing rent.

I then compared it with commercial property B, which 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.

At first glance, the yield on commercial property B offers a significantly better income stream than commercial property A, yet even a cursory consideration of the other factors confirms the much better quality of the lower initial income stream option. It could be relatively easy to extol the virtues of a portfolio of high-yielding property against a lower-yielding rival but it is likely that even short-term returns from the better quality portfolio will be higher due to the increasing income and relatively solid capital values.

Before I move on to property funds invested in equities, a couple of further issues should be noted in considering the relative strengths of different directly invested property funds. These are in regard to geographical and sector diversification.

I have already begun to note, in previous articles, the benefits to investors and their advisers of the Investment Property Databank index. As I will now explain, there is even more value to be found in this free website.

The IPD index, apart from providing statistics for average rentals, capital values and total returns from commercial property over different time periods, also divides these into sector and geographical splits. Sectors are divided between office, retail and industrial property (the latter category broadly including any type of property not in the first two categories)

In the first two quarters of 2005 there was (unusually) relatively little difference between total returns from each of these three sectors. Retail property produced slightly the worst returns but even then there was only a little more than 0.5 per cent difference between the sectors over that time period. Over previous years, there was much lower correlation.

The differences between returns from different geographical areas is well noted. London and South-east office accommodation has for some time produced much more volatile returns, both in terms of rental yield and capital values, than property in most other parts of the country.

As with most types of investment, commercial property returns tend to be cyclical and different sectors in different geographical areas go in and out of fashion over the years. What are the messages for advisers and their clients? In summary, a financial consultant advising on the merits or otherwise of dir- ectly invested property funds should ensure they are aware of the sector and geographical weighting of each of the funds under consideration against the respective performance of those weightings as revealed by the IPD index.

Finally, in making fund selections, advisers should be aware of the impact of void periods on fund performance. In every directly invested property fund consisting of a significant number of property investments, at any time there will be a number of properties which are not tenanted. This could be because of several reasons, almost all of which emanate from the inability to promptly find suitable quality tenants prepared to agree to quality leases at suitable levels of initial and ongoing rent.

Voids are relatively easy for landlords to avoid if they are prepared to compromise on one or more of these factors but otherwise they are an unavoidable fact of life for this type of property fund.

The impact of a proportion of void properties can perhaps be best illustrated by develop- ing an example from my last article, assuming a 10 per cent proportion of void properties.

Thus, it can be seen that an apparently average return on commercial property – as reported by the IPD index – of 8 per cent might translate into a return of almost 2 per cent less for the fund. Advisers projecting expected returns from directly-invested property funds must be aware of this, of course.

How do all these factors compare with property funds investing in property shares? A full discussion on this important issue will take place in my next article.

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