Commercial property has delivered strong returns over the past two years and experts predict a steady performance this year. But offices, rather than shops, may hold the greatest promise.British commercial property performed strongly over the past two years, with the Investment Property Databank UK annual index up 18.3% in 2004 and 19.1% in 2005. While property fund managers are generally not predicting similar levels of return for 2006, many are confident of high single-digit growth. Retail property generally outperformed industrial real estate, while offices lagged behind both these sectors in 2002, 2003 and 2004. However, offices were the best performing commercial property sector in 2005, with a return of 20.3%, and returns achieved by the three sectors have converged (see graph below). Property exposure in the three Adviser Fund Indices is low but all AFIs have property fund constituents. The Aggressive index had the lowest weighting (about 1%), while the Cautious AFI had 6% in real estate at January 1, 2006. Four property funds managed by M&G, New Star, Norwich Union and Scottish Widows Investment Partnership appear as AFI constituents. Dan Kemp, head of fund research at Christows, says: “We have a 5% allocation to property in our balanced and cautious portfolio recommendations. The reason we include property is as an asset diversifier but the weighting is much lower than it would have been 12 to 24 months ago. We have gradually reduced our exposure to commercial property because of valuation levels.” Kemp adds: “A few funds are collecting a vast amount of assets. In such an illiquid market, it is difficult to keep direct property weightings high. Our favoured fund is the Swip Property trust as the fund has close to 100% in real property assets and is managed by an experienced team. The fund is of sufficient size to purchase prime assets but not so large that it is a forced buyer of property.” There is a broad consensus among property managers regarding the prospects for different areas of the real estate markets. Stewart Cowe, Swip property research manager, says: “We do not expectthe exceptionally strong returns seen in the past two years to continue. Yield movements have added about 10 percentage points to annual returns over the period but, broadly speaking, the period of significant yield compression is coming to an end.” Swip predicts returns of 9.9% from property in 2006, falling to between 5% and 7% in the next few years. This is a lot lower than the past couple of years but still provides a return of about 5% in real terms, says Cowe. “Retail properties have produced good returns despite the problems in the high-street retail sector, but we do not expect the sector to strengthen,” he adds. “We expect offices to continue to outperform, although this is a cyclical trend. “Our business plan is to reduce our high-street retail position and reinvest in central London offices. This will also improve yields as offices are yielding more than shops.” While the fund has a broad geographical spread of investments across Britain, there is a bias towards properties in London and the south-east. John Cartwright, manager of the M&G Property portfolio, says: “The retail sector looks to be slowing down and prospects for offices are improving. Office vacancy rates are falling fast and this should start to push growth in the sector. “We have been underweight retail and overweight offices and have a small overweight in industrials. The warehouse component of the industrials sector can provide decent yields. But the differential between sectors is not great and stock selection is important.” Recent purchases include high-street retail properties in Reading and Falkirk. “We concentrate on diversification and our philosophy is to keep at the low end of the risk spectrum and be cautiously positioned,” explains Cartwright. He predicts strong single-digit returns for commercial property in 2006. New Star property manager Marcus Langlands Pearse says: “There are still opportunities in the retail warehouse sector but high-street retail looks difficult, with vacancy rates picking up, causing a slowdown in rental growth.” About three to four years ago, the 861m New Star Property unit trust had 40-45% in the retail sector, says Langlands Pearse, and performance of the fund suffered in late 2004 and 2005 with the shift out of retail into offices. “There is always a lag effect in property while macro factors take effect, but it takes time to reposition a fund,” he explains. The fund’s direct property holdings, amounting to just over 70% of assets, comprise about 30% in the retail sector, 50% in offices and 20% in industrial and other properties. Langlands Pearse says: “We do look across the UK but we aim to find properties that are underpinned by land and property values and with an ability to do something with the building if the tenant moves.” For this reason, he explains, there is a strong bias towards holding properties in London and the south-east. “About five to seven years ago there were some big yield differentials between London and the south-east and the rest of Britain,” he says. But yields have been squeezed and differentials are not big enough in some areas of Britain, given the higher risks, says Langlands Pearse. The Adviser Fund Index Series – A Summary The Adviser Fund Index series comprises an Aggressive, Balanced and Cautious index each tracking the performance of portfolio recommendations from a panel of 18 investment advisers. For each risk profile, all panellists specify a weighted portfolio of up to 10 funds from the authorised UK unit trust and Oeic universe that, when aggregated, define the constituents and weightings of the three AFIs (see www.fundstrategy.co.uk/adviser_fund_index.html).