On the face of it, you can certainly see why this is happening.
Given that the outlook for fixed income looks uncertain as interest rates are expected to rise and further volatility is anticipated within equity markets, physical property funds are seen as a useful tool for portfolio diversification.
Firstly, they offer a relatively decent level of income which can also grow, while they haven’t been as volatile as bond or equity funds over recent years and they also haven’t been too correlated to other asset classes either.
Because of those reasons, along with the fact that the UK economy has been in recovery mode, they have delivered a tidy return over the last couple of years.
According to FE Analytics, an equally weighted portfolio of direct property funds within the IMA Property sector has returned 15.11 per cent over the last two years, outperforming both the IMA UK Gilts and Sterling Corporate Bond sectors in the process.
While those gains are lower than IMA UK Equity Income sector’s returns, property funds have been far less volatile.
Performance of composite portfolio versus sectors over 2yrs
Source: FE Analytics
However, as more investors pile into the sector – FE data shows that the likes of M&G Property Portfolio, Henderson UK Property and SWIP Property Trust have been among the top 15 best-selling IMA funds over the past six months – Charles Stanley Direct’s Rob Morgan says a problem is emerging.
“I think a big issue at the moment is that so much money has probably gone into property funds (i.e. physical commercial property) that many have elevated cash levels, which obviously dilutes future performance – and yield, which is probably why people bought them in the first place,” Morgan (pictured) said.
“This is not an issue of size, however, more that property deals take a long time to complete so it’s difficult for these funds to absorb a lot of cash in one go.” Direct property isn’t the most liquid asset class, as you can’t just buy or sell parts of a building, and because real estate deals take a while to complete, managers within the IMA Property sector have to keep a portion of their portfolio in ‘liquid assets’ – which is mostly cash but also real estate investment trusts (REITs) and bonds – as a form of protection.
If they don’t it can cause a real problem, as investors may remember from during the financial crises.
Huge amounts of money had flown into the sector in the boom years, but as the value of commercial property began to fall, a large number of investors started to redeem their units.
Though most property managers were able to deal with those outflows, a number of high-profile names weren’t – and those examples have meant many, including a number of FE Trustnet readers, will still steer clear of the sector as a result.
New Star International Property was probably the most notorious example, but other funds run by the likes of AXA, Norwich Union and Scottish Widows were unable to deal with the mass selling and effectively locked their investors in, meaning unitholders were hit with huge capital losses.
Managers have clearly learned from the past, but as Morgan points out, investors aren’t actually getting a huge amount of exposure to direct commercial property from their direct commercial property funds at the moment because cash levels – along with weightings to liquid assets – are so high.
Source: FE Analytics
It must be pointed out that the 31.8 per cent of the F&C UK Property fund’s 40 per cent weighting to cash is cash allocated for investment. Its factsheet says the fund has an 8.2 per cent net cash weighting.
Nevertheless, our data that out of the combined £15.2bn AUM’s of those 10 funds, £3bn is currently not invested in bricks and mortar.
As a result of their structure and past grievances, many investors will only use closed-ended property funds, which have a fixed pool of assets. But they are by-no means risk-free at the moment, either.
“Property as an illiquid asset class is always going to be problematic in open ended funds,” Morgan continued.
“It’s fine when things are stable but large flows of money in or out causes issues. The hunt for yield is quite distorting at the moment and the alternative of closed-ended looks unappealing given the premium.”
Given their structure and high yields, they have attracted a lot of attention and as the table below shows it means they are currently trading on wide premiums to their NAV.
Source: The AIC
Though many investors will still pay a premium to gain access to property trusts instead of going down the open-ended route, Rowan Dartington’s Tim Cockerill says there are other risks involved.
“You can end up paying a 4 or 5 per cent premium with property trusts, which roughly equates to their yield. However, those premiums are also investors’ expectations that property prices and their NAV’s are going to rise,” Cockerill (pictured) said.
“But, those premiums are subject to the supply and demand for shares. We’ve seen it before as property trusts were trading on wide premiums before the crash and after it they fell on to quite big discounts.” “So by choosing investment trusts, you avoid the issue of inflows and outflows but you just run into another issue of discount volatility.”
These two issues combined mean that Morgan is avoiding property funds, both closed and open-ended, at the moment.
“Last year I was bullish on property but while I still quite like the asset class for diversification purposes it’s hard finding an attractive vehicle with which to invest in it right now, so I would actually ignore it for the time being,” Morgan said.
Cockerill isn’t as bearish, however.
He admits that property funds have to give up on potential returns and income at the moment due to their cash levels, as it isn’t an asset class “you can click and sell today to then buy back tomorrow”.
He also says it would be a good idea for open-ended property managers to stop money coming into their funds for short periods of time when inflows are pouring in, to make sure that their existing investors aren’t affected.
That being said, he still likes and uses property funds.
“Yes, they are not easy funds to manage, but the fact that the lessons from the financial crisis have been learned makes them a much better investment, from my point of view,” Cockerill said.
“If you are a long-term investor, which you should be with property funds, then the cost – i.e. the cash drag – is still worth it as they help to create a diversified portfolio.”
His favoured vehicle is the £1.3bn L&G UK Property fund.
According to FE Analytics, the fund – which is headed-up by Michael Barrie and Matt Jarvis – has returned 23.6 per cent over three years, beating the average bricks and mortar fund in the IMA Property sector by close to 10 percentage points.
Performance of fund versus composite portfolio over 3yrs
Source: FE Analytics
The fund is largely invested in London and the south-east, has a yield of 4.8 per cent and has 28.5 per cent in non-direct property and cash. Its ongoing charges figure (OCF) is 0.64 per cent.
