Cracks appear in bricks and mortar

The panellists keep a wary stance over commercial property as the sector is hit by devaluations in the wake of the credit crunch – and demand is falling just as supply is increasing.The dangers of commercial property have become apparent over the past few weeks.

Some British funds investing in bricks and mortar commercial property, as opposed to listed property companies, have suffered devaluations and extended redemption periods as demand has dried up.

The Investment Management Association (IMA) says inflows into property funds slowed over the summer but remained positive until October, when there were net outflows of £159m or 1% of total assets.

There are 32 UK onshore property funds. The IMA says just over half are directly invested in property. The remainder invest in a mixture of property shares, cash and other assets and will not be affected by liquidity issues.

Several factors are combining to make British commercial property less attractive to investors.

Tim Cockerill, head of research at Rowan & Co, says rental yields fell lower than the yield on fixed interest. “Why would investors put money into commercial property and take the extra risk for a lower yield?”

He adds that the economic slowdown in Britain will hit the commercial property sector over the next six months. This will reduce demand for commercial property at a time when supply is increasing, says Cockerill. “Office space in the West End of London is likely to increase by 30% during 2008 and 2009.”

These factors have led some fund managers to suggest commercial property may return less than cash over the next three years.

The net asset values of commercial property investment trusts have already fallen by between 2.5% and 5% over the past few months, adds Cockerill.

Open-ended property funds have also suffered negative returns. “Over the past six months, the New Star UK Property fund is down 11% and the Norwich Property fund is down 10%,” says Cockerill.

“Property funds hold a proportion of their portfolios in cash and listed shares to provide liquidity. But many listed property shares have suffered large falls. British Land, for example, was £17 a share in January 2007 but is now £9 a share. Obviously, this has affected the performance of property funds.”

Higher redemptions could add momentum to losses as they may lead to forced selling of property.

“The question is, when will property shares offer attractive valuations?” says Cockerill. “Isis Property investment trust, for example, was 162p per share in January but is now 110p.

“One of the trust’s biggest holdings is 14 Berkeley Square. The share price suggests the value of the property will fall by 30% to 35%, but is this realistic?”

Despite this, advisers are cautious about prospects for property funds. Darius McDermott, managing director of Chelsea Financial Services, says there has not been any change in demand from its clients because it has not actively promoted property funds in the past.

“We have been cautious about UK commercial property over the past two to three years,” says McDermott. “We did promote a structured product linked to the Norwich Union Property fund before they could be included in Isas. There was not much demand from clients, however.”

While advisers are wary about UK commercial property over the next year, they say this sector is not for short-term investments. “Property is a good diversifier as it has low correlation to equities and bonds,” says McDermott.

“Even though there are liquidity issues, investors do not need to sell. They do not have to realise losses during such periods of volatility.”

In the rebalancing of the AFI indices on November 1, the allocation to property fell in the Aggressive (3% to 2%), Balanced (7% to 5%) and Cautious (10% to 7%) indices.

This led to the ejection of the L&G UK Property Trust from the indices. But the New Star International Property fund was a new entrant to all three AFI indices.

Cockerill says the New Star International Property fund is popular with advisers because of its exposure outside Britain, particularly in Japan and Asia. “The Asian property market looks to offer better value than the UK and continental Europe.”

Ben Willis, head of research at White-church Securities, says it switched out of UK property funds in April 2007 as it was concerned about yield compression and “over-inflated” prices.

“The New Star International Property fund provides diversification because the property cycles in other countries lag or are different from the UK’s,” says Willis. “We favour direct property over property shares for their diversification benefits. Property shares are a bridge between equities and direct property.”