Moving back to commercial property

Many investors suffered losses in the crisis last year and the diversification theory was found wanting. But is it time to consider other assets again, namely the commercial property sector?

News that commercial property might be coming back into vogue has raised a few eyebrows from investors who were caught up in the capital flight from the asset class last year.

After the halcyon days of the early 2000s the sector suffered almost two years of a bear market, so many investors could be forgiven for having their reservations about the prospect of a sharp recovery.

Their scepticism is shared by Adviser Fund Index (AFI) panellists, but they say despite the risks the sector could provide interesting opportunities for discerning investors.

“Property seems to have reached a bottom and its now bobbling along, so there’s less downside risk than there was,” says Sam Sibley, a portfolio manager at Beckett Financial Services. “There is still a lot of economic uncertainty, however.”

The question is what might be compelling investors to ignore the potential macroeconomic risks and jump back into the asset class. James Davies, an investment research manager at Chartwell, says from an historical perspective British commercial property is presenting an opportunity. “In terms of investment logic,” he says, “if you have a decent time horizon commercial property offers good value at the moment. You need to be careful, however, that if liquidity becomes a problem you can get your client’s money out.”

Davies’s argument appears to have weight. Much of the money currently flowing into property funds has come from institutional and discretionary sources.

Panellists say that despite its potential appeal retail investors have remained cautious about dipping their toes back in the sector. Sibley says much of this can be attributed to the unprecedented volatility in the sector in recent years, which has belied its status as a defensive holding.

“People got carried away with it when it was producing 20% a year,” she says. “Really, property has always been an income providing diversifier.”

Last year the diversification theory was found wanting, as a high degree of correlation across asset classes meant portfolios holding a multi-asset portfolio saw little protection from the capital losses. It led to serious questions about the benefits of holding a variety of assets, as everything but cash and government bonds was battered by the financial crisis.

Davies says the crisis has not undermined diversification, but it has given investors a warning that different assets are more interconnected than they thought.

“It’s a basic principle that had you held cash and government bonds you would have been cushioned, so diversification did work,” he says. “The problem was people were all in the same asset classes.”

The inability to predict the severity of the crisis left many exposed to some of the worst investment losses in a generation. Davies says he is concerned that diversification has been “pushed into the background” when it should be the focus of portfolio construction.

While an immediate return to a property bull market is not being predicted, panellists are saying there are some good short-term reasons for investing in property. The income component of commercial property is seen by panellists as a key factor behind the recent interest in the asset class.

With the Bank of England’s base rate being held at 0.5% returns from cash and money market funds over the past year have been negligible. Although in 2008 a 0.5% return would have been a success relative to falls of about 30% in equity markets, the sharp rally in equities since March has made it look appealing.

“There has always been a place for income seekers in commercial property,” says Davies. “Yields are up around 8% at the moment so they are looking attractive.”

The combination of a high yield and lower downside risk that is being seen in the British equity market has left property appearing to be an increasingly attractive proposition.

Despite its return to net inflows in May, according to the Investment Management Association (IMA), Davies says the sector is still facing competition for the attention of investors.

“You might say that there are opportunities for income growth in equities, which are maybe more attractive,” he says.

Sibley agrees that there are still challenges to be faced before property inflows return to their pre-crisis peaks. “You’ve already seen huge inflows into corporate bonds, as people whose natural home would be cash have moved into them,” she says. “Corporate bonds are still attractive, but I would be more picky about the funds I invest in. You’ve also seen flows into equity income, but not as much as some managers were expecting.”

Given the perception that the equity market rally may prove unsustainable and the market could see another slump before it returns to a protracted growth trend, liquidity concerns will still play a significant part in decisions. This is particularly true for the retail market where investment time horizons tend to be a shorter duration than for institutions.

“The main thing for me is how big the door is [in property funds] and how much money is in the room,” says Davies.

These concerns are likely to stifle the flow of retail money into property while economists continue to predict a subdued and sub-trend economic recovery for Britain, although the upside potential could prove temptation enough for some.

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