Everything you need to know about property funds
10-23-2014
Investing in commercial property potential adds another asset class to, and thus increases the inherent diversification of, an investor’s portfolio.
Traditionally seen as an ‘alternative’ investment, until the launch of a number of tax-efficient investment vehicles, life companies and property company shares were seen as the only access to this asset class for investors, rather than direct investments.
A commercial property is normally seen to be a larger lot size than residential and as such pooled investments, professionally managed, are a good way to access the asset class. This is because property investing involves purchase, ownership, management and rental, or development and sale of ‘immovables’.
The basics
A ‘bricks and mortar’ investment - and even if held indirectly all commercial property investment is ultimately such - is typically seen as a store of value and a provider of a stable, relatively high income stream over the long term. The security of each determines different levels of risk to the investor.
In the UK, commercial property normally reflects the movement of GDP growth, but as a result quantitative easing institutional money borrowed at cheap rates is being channelled into the sector, isolating it from weak or strong economic activity.
Some advisers argue that most clients already have exposure to property through their main residence, so they don’t need any more
From an adviser perspective property investment tends to place the community into binary camps. On the one hand, some argue that most clients already have exposure to property through their main residence, so they don’t need any more. Or that other clients have enough exposure because they have decided to expand their investments to include ‘buy-to-let’ properties.
Others feel that residential property has a different dynamic to commercial and therefore exposure to this asset class is warranted. It is generally accepted that residential has different characteristics in investment terms to commercial property and could therefore be seen as a separate asset class.
As an asset class it has also been shown to be negatively correlated to others; in other words its ‘price’, or value, moves differently to equities and fixed interest.
Property is not exchange traded and is usually transacted as a ‘matched bargain’ or through different types of auctions. A fair value can be determined using a set of criteria, but the price paid will always be what the purchaser is willing to pay and the vendor will to accept.
Having said that, properties that throw off a steady stream of income from rents, can be seen as a ‘bond proxy’.
Risk profile
Property is not a readily realisable asset, since it usually takes between three and fours months to buy or sell. The transaction is complex when compared to other investments, using a layer of agents such as lawyers and surveyors, so liquidity becomes an investor concern.
Although in times of market stress, a buyer can be found, the slowness of receiving proceeds affects investors, especially if they are ‘levered’: borrowed money to buy using the asset as collateral.
Also, the fair value of the asset, the ‘market to model’, is usually higher than the realised valuation, the ‘mark to market’; a sale can always be made ‘for the right price’. As such risk measures normally used for equities and bonds, which are priced daily, are not appropriate for property.
Property valuations are comprised of a number of factors. Principally, it is made up from the income generated through rents and also the capital value. Properties that are designed to offer secure income are deemed to be a lower risk than growth orientated investments, those bought to be developed and sold on for a capital appreciation
For example, a core property is one that ‘anchors’ a portfolio and has a large lot size. It has a super long lease, such as 25 years, with long break clauses, upward-only rent rises; the tenants are not affected by vagaries of the economy and the rent is easy to collect. And the tenant has to maintain the building.
Conversely, a speculative investment is one that is focused on capital growth, for example borrowing money to develop a brownfield site. The typical example is converting an old bank branch into a trendy wine bar: a major risk here is that the developer is exposed to consumer demand and directly linked to the economy.
Of course, there are other properties that are a combination of the two examples mentioned here. So risk profiles can be categorised from lower to higher as properties with:
• Secure income and super long leases
• Capital and income that are inflation hedged
• Capital and income development
Types of properties and funds
The market can be split into four sectors:
• Industrial: warehouses and manufacturing
• Commercial: offices and business parks
• Retail: ranging from corner shops to shopping malls and out-of-town retail parks
• Esoteric: including ground rent, student accommodation, caravan parks and hotel rooms
Property comparisons are usually made by price per square foot, yield generated, length of tenant leases and quality of tenants.
In terms of the fund types investors can select from, as properties are not easily transferable they do not sit within the usual Ucits structures. Therefore, there are three main types of funds, investors can use in the UK:
• Real estate investment trusts
Reits were launched in the UK in 2007, when a number of well-know traditional property companies converted their shares into this new structure.
The most compelling reason for this move is that the funds are exempted from paying corporation tax. As part of the regulation they must pay out out at least 90 per cent of rental income to shareholders and must be predominantly engaged in property investment and not development or other economic areas.
As they are listed, they are deemed to be more liquid than a direct property investment but also more volatile in the short term. Longer term, it is expected that Reit net asset value would be closely correlated to direct property.
As is usual with investment trusts, shares trade at a discount to net asset value, which can widen or narrow depending on supply and demand factors.
Distributions are paid after withholding tax at the basic rate is levied. However, they can be paid gross to appropriately registered investor classes such as charities, UK corporates, pension funds and Isas.
Property authorised investment funds
As opposed to closed-ended Reits, Paifs are open-ended, which can allow for a better correlation with the underlying asset class. The structure was launched in the UK in 2008 as a new open-ended type of fund, to provide a tax efficient and flexible access to property investment.
After a slow take-up, because of the credit crunch and some tax hurdles, there has now been a number of conversions from the old style authorised property unit trusts, where distributions were not tax efficient for the investor, into these new types.
Paifs, which are Oeics and not unit trusts, allow for gross distribution payments to qualifying investors such as charities, pensions and Isas. As such there are three types of income typically available:
- Property rental
- Dividends, for example from Reits
- Interest from cash
At least 60 per cent of the asset value and income must be deemed to be from property investment business to qualify. Others qualifications include measures that stop individuals benefiting personally from a pooled investment vehicle’s tax breaks, for example capital gains tax exemption.
Paif shares must be widely available to a broad range of unconnected investors, something shared by all collectives. Also the fund must take reasonable steps to prevent 10 per cent or more being acquired by a single entity.
Unlike Reits and similar to other Oeics, Paifs can have a number of different types of share classes, such as income and accumulation, and retail and institutional. They can even have clean share classes.
Life and pension funds
A premium or contribution is paid to make an investment in these types of funds. Traditionally, they were invested in large direct properties for the long term with monies from non-profit and with-profit funds.
Life offices were the major investors in UK commercial property, focused on core properties in the main and not with the development of land banks, as were the property companies. They had the resource and, more importantly, the time horizon to allocate to this asset over the business cycles.
With the advent of unit-linked, and more so, the choice of investors to increase their exposure to commercial property, demand for quality properties increased as money flowed.
During the last commercial property bull market, because of the time delay of receiving investor cash and then buying a property, many life company funds were sat on a stockpile of cash, which acted as a performance drag and made their performance numbers uncompetitive.
(Similar concerns are now being aired about other commercial property vehicles as a recent of recent flood of cash into the sector seeking an alternative income stream.)
Derivatives and synthetic property vehicles were used to plump up the fund valuation. As the market flipped and investors wanted to remove their capital from typically daily-priced funds, and if their derivative contracts could be sold via the counterparties, fund managers were forced to suspend dealing, as accepting deeply discounted bids for the fund’s property sales would not be seen to be treating the remaining investors all that fairly.
Changes to tax rules makes life funds directly invested in property accessible via onshore investment bonds not as attractive as pension funds for individual investors.
A case for property investment
The essence of asset allocation is to spread your money across different investments that are not correlated with one another, so that in the accumulation phase of investing, no one area greatly impacts the portfolio, negatively. You look to introduce assets to reduce volatility rather than enhance returns, assuming a starting point of 100 per cent risk assets.
‘Bricks and mortar’ has usually been perceived as being a safer investment than others, though not without its own risks. But it is as an alternative to dividend and bond income, for the decumulation phase type of investor, and commercial property investment vehicles, with stable and secure incomes, could well be appropriately used more.
Frank Potaczek is head of insight and consulting (investments) at Defaqto