Time to move back into property?

As the UK commercial property sector sees a sustained rise in prices, Julian Smith, fund director of F&C UK Property, says now might be the time for investors to move back into bricks and mortar.

The residential market has been experiencing a number of setbacks as the economy adjusts to a period of fiscal austerity. Conversely, the UK commercial property sector has, over the past year, seen a sustained rise in prices and this has subsequently attracted a range of investors to the sector.

As a result, it would appear investing in property is becoming far more mainstream. Indeed, data from the Investment Management Association (IMA) shows investment in property has risen 20-fold over the past nine years. What perhaps makes this sector attractive to investors is those who wish to invest in the UK commercial property market can do so in a variety of ways.

Investors can hold property directly, buy property shares (including REITs) or invest in property market instruments such as derivatives. Each of these has different attributes and could therefore be suitable depending on the investor’s individual needs.

Below we look at the arguments for and against the different types of investment in direct property.

Direct investment vs shares

The big advantage direct property has is it is lowly correlated with both bonds and equities. Property shares, in contrast, can be influenced by factors governing the equity market as a whole and therefore perhaps does not always offer the same level of diversification. As such, direct property may be the better bet for an investor who is attempting to diversify risk within their portfolio.

Investors who believe property is set for a period of outperformance may prefer to restrict their exposure to the asset class itself rather than have returns diluted by the influence of the equity element in property shares.

Moreover, property share prices have the potential to be more volatile than direct property. It has been argued in the past this stability is a reflection of the less frequent valuations of direct property in addition to a valuation system that relies on comparative evidence rather than the harsh realities of real-time pricing in the open market.

As a result, there is some smoothing of pricing for direct real estate. While there may be some truth in this argument for the investor who is looking for exposure to a property asset with less volatility, nevertheless it remains the case direct property has historically proved to be the better option. This of course, as with any asset class, cannot be predicted with certainty for the future.

The yield on property equities has also been significantly lower than for direct property and this may be a factor for investors who are looking for a high and stable income stream, particularly as many investors have been seeking a source of sustainable income while interest rates remain low and look set to do so for some time yet.

Direct vs derivatives

One of the great advantages of property is each individual asset is different. We believe outperformance can be achieved not just simply by choosing the right sector but also the right asset. Assets in the right location, with a solid and secure income stream and good re-letting prospects would be expected to outperform. It is also possible to enhance value by identifying underperforming or mispriced assets and adding value by upgrading the stock, reducing voids or re-configuring the tenant mix.

We believe this is not a trivial consideration. IPD data for 2009 showed over the past five years the fund on the top-quartile boundary registered almost double the total return of the median fund and six times the return of the lower quartile.

However, investing in derivatives does not always give the investor exposure to outperforming management, which puts it at a disadvantage when compared to direct property investments.

Counterpoints

The key arguments against investing in direct property have traditionally been its low liquidity, large lot sizes and high transaction costs. While, for example, an average lot size of more than £20m [Property Data Jan-Sept 2010] can be daunting for the small lone investor, the industry has recognised the attractiveness of the sector and subsequently been quite active in providing products that attempt to overcome these obstacles.

Open-ended funds are available for a relatively small initial outlay. The risk is spread by pooling resources with other investors to gain wide exposure to assets and units that can be quickly and easily redeemed. It is of course not a perfect system, and in times of stress funds can be temporarily closed for redemptions.

Even so, these types of investments do provide a measure of price protection for continuing investors, which are not available to those investing in other property related investments, such as shares.

In addition, there are times when the cost of transacting can be absorbed relatively quickly, as those who bought direct property around one year ago can readily testify. These points aside, we would contend direct property is best suited to investors seeking to hold the asset over the long term.

Austerity challenges

The coming year is expected to be challenging for everybody, particularly once austerity measures start to bite. Direct property has traditionally delivered an income return of more than 6% pa, which is far better than the rate available on other asset classes and cash currently. For those investors seeking a steady and relatively high income stream, investing in UK direct commercial property could represent an attractive alternative option.