Property sector sees rising fund sales for third year

Property funds were the big product story of 2006, and one that does not appear to be concluding anytime soon. Quarterly net retail sales have risen in an unbroken pattern since the end of 2003, but the curve has become much steeper this year, according to data from the Investment Management Association.

First and second-quarter sales of £590m and £820m respectively were impressive, but were soon eclipsed by third-quarter sales of just under £1bn – more than property inflows for the whole of 2005.

Investors have more choice than ever within the sector, and the launch of Seven Dials’ Guernsey-domiciled European Property fund – reported in last week’s Fund Strategy – was the latest in a long line this year.

On the onshore, open-ended side alone, L&G, Franklin Templeton, Scottish Widows Investment Partnership, JP Morgan, Fidelity and First State all unveiled at least one new portfolio each. The Specialist sector now contains 22 property portfolios, 16 of which have been launched within the past 18 months.

The reason for this glut of launches and sales is ultimately performance. According to Standard & Poor’s, the 14 property portfolios launched prior to 2006 generated an average return of 23% between January 2 and December 11.

However, some funds have performed well above that figure – Aberdeen’s Property Share portfolio, for example, returned 38%. Compared with an average return of just 15% for the UK All Companies sector, it is easy to see why investors are so keen on the asset class.

But are these returns, and the inflows that inevitably follow, sustainable? Gerry Ferguson, investment director of property at Swip and manager of the firm’s £1bn Property Trust, says he expects less dramatic performance in the medium term.

“We are forecasting 6% per annum over the next five years,” he adds. “There may be unreasonable expectations at a private individual level, but most IFAs do not expect a continuation of double-digit returns.”

Ferguson’s strategy for the immediate future is to focus on the office sector in central London and the south-east. In particular, he looks for strong rental growth, properties with fixed rental uplifts and added value opportunities, where rental income can be increased. By focusing on the prime end of the market, Ferguson hopes to avoid the worst of any macroeconomic downturn.

He says: “There is likely to be a greater softening of yields in secondary property in the middle of 2007. We are looking for properties with long leases and good covenants.”

However, some investors appear to expect a repeat of 2006, according to a joint survey by the Association of Investment Companies and IFA Promotion. In a poll of 170 IFAs, 28% expected property to outperform equities and bonds in 2007, with 12% predicting that property would be the top-performing sector overall.

The survey also found that, in a pool of 31 AIC member companies, 77% of fund managers expected equities to outperform, compared with a rate of just 55% among the IFAs. None of the fund managers thought property would provide the best returns.

Jonathan Gumpel, a founder director of Brooks Macdonald Asset Management, says much of the new money going into British commercial property is being invested on “pretty steep terms”.

He says: “There has been such a focus on property – from private individuals, pension funds and international investors – that there is limited scope for further capital appreciation.

“You can see this with investment trusts, where the big premiums are fading away and some are moving to discounts. It is a sign that professional investors are not as confident as they were.”

Brooks Macdonald has increased its exposure to property over the past three to four years, but is now cutting back. Gumpel says the firm’s allocation to the British market has reduced by half.

Nick McBreen, an adviser at Worldwide Financial Planning, is also wary on over-investment in domestic property, but expects a soft landing for the sector rather than a crash. McBreen says: “Advisers have to be careful on how much exposure their clients have and where it is invested.

“Some investor portfolios have 40% in property. I am more comfortable with 4-5% and do not subscribe to the view that property is the thing for the future. The sector will not keep going at 18% per year.”

However, British investors do not necessarily have to invest in British property. Five of the funds launched in 2006 carry global name-tags and Gumpel says there are still ways to make good returns from the asset class.

He says: “There is a good chance that interest rates will rise, and the UK residential and commercial property markets will become vulnerable.

“We have been using the European and Japanese markets. Good-quality commercial property is on yields of 7% in Europe, while UK property prices have had a significant spike. Japanese residential property also looks cheap.”

Although McBreen is cautious on the outlook for the British market, he expects investor interest to increase further with the arrival of the real estate investment trust “juggernaut” next month.

Reits are designed to offer income and capital gains from rented property in a tax-efficient way, and Reita is leading a campaign to raise the profile of the trusts. The organisation expects a number of property companies – including Land Securities and British Land – to convert to the structure.

The arrival of Reits will bring Britain into line with the established markets of America, Australia, Belgium, Canada, Singapore, Japan and France. As reported in last week’s Fund Strategy, the government announced a relaxation of the Reit rules in its pre-Budget report.

The trusts will have a one-year grace period from the income and asset test, allowing new vehicles to list on the stockmarket before acquiring assets.