Title fight

Since achieving Isa status in January, commercial property has proven popular with investors, and funds are now being launched that invest in residential property too. But how do the two sectors match up? Adam Lewis finds out.

Given the high returns of the commercial property sector over the past two years, it is hardly surprising that it has become so popular with British investors. According to the Investment Property Databank, in 2004 and 2005, the commercial property sector delivered returns of 18.3% and 19.1% respectively, while over three years the annualised return is 16%. On top of this, the Royal Institute of Chartered Surveyors has forecast returns for the sector in 2006 to remain healthy at 17%.

On the back of the strength of the sector, over the past two years several fund management groups have launched open-ended funds investing in British commercial property. M&G, New Star, Norwich Union, Resolution and Scottish Widows all manage investments in the asset class, which is worth 140bn, according to the IPD. Indeed, at the end of last month the Property fund run by New Star surpassed 1bn of assets under management, while the Norwich Property fund stands at 2.5bn.

The popularity of these funds was enhanced further at the end of last year when they were granted eligible status for Isa investments. Up until December 27, 2005, investors who wanted to invest direct in commercial property could not do so via an Isa wrapper. This is because the funds were structured as non-Ucits retail schemes, which were not classified as Isable investments.

However, having only been granted Isa status in January, commercial property is proving popular among investors this year. According to the Investment Management Association, the best-selling sector by net retail sales in the first quarter of 2006 was the specialist sector, of which it has been suggested that most sales were into British or global commercial property funds.

The British commercial property sector is, however, dwarfed by the residential property sector, which, according to property fund manager Cordea Savilles, stands at 3.3trn. This is treble the 1.1trn it stood at in 1995. But while direct home ownership is most investors’ biggest investment, in last year’s pre-Budget report, Chancellor Gordon Brown ruled out the use of direct residential property being held in self-invested personal pensions.

However, one month on from A-day several groups have begun launching and promoting funds that invest in British residential property and that can be held in an investor’s Sipp. Given the strong returns available from the commercial property sector, and the fact that most people’s biggest investment is their home, is residential property an asset class investors should be considering?

Marcus Langlands Pearse, property manager at New Star, says the two asset classes are fundamentally different. In terms of leases, he says, in buy-to-let, property leases are generally on 12-month break clauses, whereas for commercial property, standard leases are 15-25 years. He says: “Compared with buy-to-let property, where you have a single tenant whose quality and financial history is not guaranteed, in commercial property you deal with multiple, often blue-chip, tenants.”

This, he says, adds greater security to commercial property funds. In rent terms, he notes, residential property leases are renegotiated yearly and could go up, stay the same or even go down. While in contrast, commercial property rents are typically negotiated every five years, in an upward-only direction, giving an assured level of income.

“As an asset class, commercial property is geared to the wider economy,” says Langlands Pearse. “The residential market is much more volatile, in that a lot of its returns are derived from capital growth, not income streams, as is the case with commercial property.”

Indeed, according to New Star, while the returns made from residential property have been higher than those from commercial over the past five to 10 years, 80% of the return has come from capital growth. In the case of commercial property, Langlands Pearse says, 80% of the return has come from rising income.

In addition, Langlands Pearse questions why investors would want to increase their exposure to residential property, given the fact that for the majority of people their home is their biggest investment.

Despite the differences noted by Langlands Pearse, John Buckley, property economist at Morley Fund Managers, says strategically the two asset classes have a lot in common. On top of this, he adds, both have a number of benefits for investors who want a diversified portfolio of assets.

“When you construct a balanced portfolio of different assets you need to take a view on three things,” Buckley says. “First, the return from each asset class; second, the risk associatedwith each; and finally, the correlation between them.

“Ideally you want assets that are uncorrelated, as the portfolio would contain less risk. Commercial property and residential property are asset classes that are lowly correlated with equities and bonds. As a result, both are useful in a balanced portfolio.”

The difference between the two asset classes, Buckley notes, is that commercial property has been more accessible to investors as there are more funds that invest in it. “The principal reason for this is that commercial property is more easily managed,” he says. “The properties invested in are bigger and worth more money, while in residential property the units are much smaller, making them more management intensive.”

Small units are, however, the type of investment in which the newly launched Garland UK Residential Growth fund is looking to invest. Opened for investment in April, the Jersey-domiciled Oeic, run by Garland Asset Management, invests in residential property below the 120,000 stamp duty threshold in the north of England, Northern Ireland, Wales and Scotland. The fund, which can be held in offshore bonds and Sipps, aims to generate minimum growth of 10% a year.

Janine Daines, co-founder of Garland Asset Management and lead manager of the new fund, says there is no correlation between the returns achieved in commercial and residential property.

While noting the recent strong run of commercial property, Daines argues that its yields are now starting to fall. She says commercial property also exhibits a largely uncontrollable vacancy factor and that values and rents in the sector tend to be closely associated with the level of economic activity, and as such are vulnerable to the effects of over-supply in a recession.

“During the economic downturn of the early 1990s, many suburban shop premises were vacant for several years and, in some cities, the vacancy rate for offices in certain districts reached 30%,” she says.

Daines adds that commercial property also tends to have a high unit cost, requiring a minimum investment of several thousand, or more often several million, pounds in a single building.

“The cost per unit of residential investment property is substantially less, enabling a number of units to be purchased with the same amount of capital as might be required to buy a singe commercial premises,” she says. “This means when one residential unit out of a number is vacant, the loss of revenue is less dramatic and can be carried by the others. Another attraction of residential property is that it is generally easier to dispose of, should it become necessary.”

The Garland fund is not the only fund investing in British residential property. Daines’ former employer Pacific Continental Securities has run a UK residential property fund, called the Skylight Capital Build Up fund, since March 2004 and Cordea Savills launched the Diversified Residential Opportunities fund in April this year, especially for private investors.

Similar to the Garland fund, the Isle of Man-domiciled Skylight Capital Build Up Oeic invests mainly in the north of England. It too aims to return 10% a year and invests in rental properties that fall under the 120,000 stamp duty threshold.

The Cordea Savills fund is different, however. Rather than invest in buy-to-let properties, the open-ended fund invests in more specialist residential property, such as student accommodation, elderly care homes, hotels and properties let on long leases to housing associations, National Health Service trusts and universities. It aims for a return of 8% a year. Andy Allan, head of research and strategy at Cordea Savills, says all these areas of the market are not as correlated with house price growth as the traditional buy-to-let sector. Therefore, he notes, their income streams are much more stable.

As well as producing numbers for the commercial property sector in the IPD Annual Index, the IPD also covers residential property in the IPD UK residential investment index. In 2005, compared with the 19.1% return from the commercial sector, the British residential investment index grew by 8.1%. However, Allan says this figure is not all that it seems.

“The residential index only covers the sort of homes we live in – that is, market-let properties,” he says. “However, the IPD also examines other residential segments of the market [care homes, student halls, social housing etc] that sit outside its residential index, but it does not report on them. These areas of the market achieved 20.3% in 2005, which beats the return made by commercial property.”

Allan says that Cordea Savills first became cautious on the direction of house prices two years ago. While not predicting a slump, the view now is that prices will moderate and that capital growth is slowing in the sector. “Most expectations are that house price growth will be broadly in line with earnings growth at about 3-4% per year over the next five years,” he says. “This is much lower than the returns buy-to-let investors have experienced over the past few years.”

It was for this reason that Cordea Savills looked at the alternative segments of the residential property sector. In addition to generating double the returns of buy-to-let properties last year, Allan says, the average lease length is much longer in the specialist areas. In student halls of residence, for example, the fund is buying properties on leases of 20-years-plus, he notes. “This is much longer than the leases obtainable from offices, shops or industrial units in the commercial space,” he adds.

Indeed, according to data from the IPD, the average long lease expiry in the commercial property sector in 2004 was just under 10 years. In 2005, commercial leases, as measured by theBritish Property Database, were just over six years.

In addition to the long leases of student accommodation, Allan says the rents are negotiated on an upward-only basis similar to commercial property. This means their level of income is more solid than typical buy-to-let properties.

The emergence of sub-sectors within residential property brings the sector into line with commercial property, where managers have the choice of investing in retail, office or industrial properties. At present, Langlands Pearse says, 30% of the New Star Property fund is held in retail, 50% in offices and the remainder in industrials.

In terms of future returns, Buckley says while there are no signs of a slowing in the commercial property sector so far this year, it will slow eventually. “We expect the slowdown to start taking place in the second half of the year and returns to steady to their long-term average of roughly 7% per year, in nominal terms, for the next five years,” he says.

“As we don’t invest so heavily in residential property, we don’t tend to make forecasts in as much detail. However, we would expect the return to be not too different to commercial property over the coming years.”

While the returns may be similar, Daines says as the asset classes are very different there is room for both in an investor’s portfolio – a view that is shared by Buckley. He says: “This does not need to be a case of one or the other. Commercial property funds have the longer history and are more accessible, whereas the newly launched, or launching, residential funds are less well known and, as a result, are harder to access.” Indeed, one drawback of the newly launching residential property funds is their high costs. While qualifying for investments into Sipps, as the Garland fund is classified as an expert investor fund it has a high minimum investment of 75,000. As the Skylight fund is classified as an experienced investor fund it has a lower minimum investment of $15,000 (8,200), while the Jersey-domiciled Cordea Savills fund has a minimum 10,000 investment. As a result, they are not as retail investor friendly as their commercial property counterparts, but this is not necessarily the marketplace at which they are being aimed. Indeed, Daines says the fund is targeting high net worth investors and private banks.

She adds: “Many investors have ignored residential property because of its smaller unit size, which means it is more costly to manage. Unhelpful legislative imposition in the past has also meant the sector has suffered from a poor image, and for many years it has been considered unglamorous.

“However, standards have risen in recent years, not only in the physical condition of the properties themselves but also in the calibre of tenants, the performance of professional property managers and the creation of sophisticated property funds that allow investors an opportunity to receive hands-off exposure to the asset class.”

It will indeed take time for residential property funds to build up the track records of their commercial property counterparts, but such are the differences between the way they are managed that they should not be perceived as a threat.

Just as there are many sub-sectors in which to invest in commercial property – offices, retail and industrial – the same is true for residential property. Rather than just invest in second homes, investors who want to increase their exposure to the asset class can now do so via managed funds, which not only invest in different regions of the country but can also hold different types of properties, such as buy-to-let, student accommodation, elderly care homes and NHS trusts.

Commercial property managers and promoters of the sector are quick to point out its advantages over residential property. However, given the expected slower returns of commercial property, the enormous size of the residential market and the new funds coming to market, it is an asset class that could easily capture the imagination of investors.

The retail and pension views

Retail: Mark Dampier, head of research at Hargreaves Lansdown.
“While I admit to calling commercial property wrongly for the past two years, I limit our IFAs to only investing about 10% of client portfolios in the asset class. While those invested in the sector over the past two years have done well, for me the sector has become too fashionable and it is just the sheer weight of money going into it that is pushing commercial values up. The fact commercial property yields are now the same as the yields on 10-year gilts also worries me, as I am not sure investors are being compensated enough for the risks they are taking.

“However, I think investors would be more mad to invest in residential property. While it looks like house prices will continue to rise for the time being, sooner or later problems will emerge as first-time buyers continue to be frozen out of the market. There also now seems to be a presumption that interest rates will not go up again. However, for those borrowing three and a half times their income to buy a house, if rates rise 2% from their current level it will cause serious problems.”

Pension: Jamie Fergusson, pensions development manager at Jupiter.
“The British public have an ongoing love of bricks and mortar and have embraced property as an asset class. However, the risk with property is that it is cyclical – it can go down as well as up. But people seem to have forgotten this. It is not a one-way bet, either in a pension or outside of one.

“This is why the decision to exclude direct residential property from being held in Sipps was a good move. For the majority of people a fund, be it invested in commercial or residential property, is a better way of getting exposure to the asset class than investing directly in it. This is because a fund allows more liquidity and greater diversification geographically.

“I would agree that residential and commercial property are not aligned or correlated to each other, but I am hesitant to say just how much of clients’ pension portfolios the two classes represent. While I cannot generalise all clients, I am unlikely to put more than 25% of a portfolio in property [both commercial and residential]. However, if there is a niche opportunity that is suitable for a client, that could increase.”

Funds investing in global property
In addition to several UK commercial property funds, investors can now invest in a growing number of global property securities funds and global real estate investment trusts (Reits).

Fidelity, Hendersons, Morley, Schroders, Skandia and Franklin Templeton have all launched funds investing in global-listed securities and Reits. The biggest difference between these and UK commercial property funds is that they invest in the listed shares of property companies rather than bricks and mortar.

Steve Buller, manager of the Fidelity Global Property fund, says it invests in the companies that themselves invest in offices, retail property, industrials and hotels. At present, the fund also has 16% of its assets invested in the residential sector of the market, two-thirds of which is held in American apartments.

While noting the recent launches of UK residential funds, Buller says as yet no global residential property funds have been established. As a result, he notes, the current crop of funds are entirely exposed to one country, meaning they are at risk to just one macroeconomic and interest rate environment.

The global property securities funds, meanwhile, are diversified globally, with the Fidelity fund currently holding half of its assets in America, 10% each in Japan,

Australia, Britain and Continental Europe, 7% in Hong Kong and 3% in Singapore. Buller says: “We did not launch our fund just because we perceived it to be a hot sector. The group had looked at this sector for about 10 years and we now perceive the universe as large enough to invest in, and can see future growth in the industry as more countries adopt the Reit structures.”

Jim Rehlaeder, manager of the Schroder Global Property Securities fund, expects to see growth in opportunities in office properties in Paris, London’s West End and Tokyo. In terms of types of properties, he says he is looking at retail warehouses and shopping malls, particularly the better-quality, better-located properties, as he says these will perform the strongest in the event of a consumer slowdown.

He says: “The expansion of the property securities market is gathering pace and a big driver of this activity is Reits. The recent confirmation of a Reit structure in the UK, and with Germany expected to follow suit, means the investment universe continues to grow.”

Buller’s one major note of caution for the asset class is that owing to its perceived boring status, people may forget to add it to their portfolios if a more “sexy” sector emerges, as technology did in the late 1990s. “For the past decade, property has outperformed equities because of its dull and boring nature,” he says.