Britain’s growing economy has led to a commercial property boom, hiking up tenant’s demands for office, warehouse and shop space.
What’s more, as investors scrabble around searching for yield at a time when it is thin on the ground, property is continuing to outperform global equities and has returned to favour after investors got their fingers burnt in the financial crisis.
Performance of sector vs UK equities over 2yrs
Source: FE Analytics
Chris Metcalfe (pictured), investment director at iBoss, said: “This is good news considering our property holdings and our portfolios overall, however, we still have concerns regarding the size of individual funds and the flows going into said funds.”
Data from the Investment Association shows the IA Property sector witnessed £3.8bn in net retail inflows over the course of 2014.
The pace of inflows into the sector’s most popular funds has prompted Metcalfe to change how he gets exposure to UK commercial property.
Over the last two years, iBoss has removed numerous funds based on fund flow and fund size considerations. In its most recent changes, the firm replaced the £3.1bn Henderson UK Property fund with the BlackRock Global Property Securities Tracker and L&G UK Property funds.
Metcalfe said: “Property has become a very popular sector and this has led to concerns about just how much money the Henderson fund is taking in every day. We have been here before with flows into property funds back in 2007/08 and, while all the teams say lessons have been learnt and the cash holding has been increased to around 20 per cent, our concerns remain.”
Inflows of nearly £4bn into UK commercial property funds over the past year have boosted the sector’s total assets to more than £24bn. But this has caused some concern.
Meera Hearnden, senior investment manager at Parmenion, said: “There have been large inflows into the property sector and, while this may be of concern if the flows continue to remain strong, the important thing to focus on is how the flows are being managed.”
“Some managers such as M&G have been able to invest the money into high quality secondary property where there remains attractive value. Others may have higher cash levels as they are unwilling to purchase any low quality property such as L&G.”
“While this could prove a drag on short-term returns, at least they are sticking by their investment discipline. “
M&G Property Portfolio is the biggest fund in the sector, with assets of nearly £4bn. It currently has a yield of 3.94 per cent, a low FE risk score of 36 and a negative correlation to FTSE All Share over five years.
L&G UK Property, also one of the largest property funds at nearly £2bn, has a slightly higher yield of 4.1 per cent, an FE risk score of 21 and a correlation of 0.40 to the index.
The low risk and the current yields that many property funds provide seem to outweigh concerns of fund size for many investors, although many concede it is something they are keeping an eye on.
Ben Willis, head of research at Whitechurch Securities, said: “The attractive yields and its lack of correlation with both bonds and equities has seen large inflows into commercial property.”
“However, I don’t think it is a problem yet as there is enough supply on the market to meet demand. Nevertheless, we started allocating back into commercial property funds in Q4 2009 as we were attracted by the yields available.”
“Now it has become a consensus position as a replacement for bond exposure, given the outlook for bond markets. As such, funds have more than doubled in size since we first went back into the asset class.”
“We are keeping a close eye on it but remain unperturbed for now.”
Rising interest rates are indeed steering investors away from once-reliable bond funds and pushing them towards the property sector. However, this climb in assets isn’t necessarily a bad thing for the asset class.
Mike Deverell, investment manager of Equilibrium Asset Management, said: “There are both benefits and drawbacks to having large property funds. The benefits are that large funds can own really interesting properties, like shopping centres in the £100m bracket.”
“Large property funds can also spend money on developing these properties. For example, renovating buildings or even adding new units, as SWIP (now Aberdeen) did with their Edinburgh retail park when they built a Krispy Kreme.”
“This lead to more people visiting the retail park. This can drive up rents and therefore property values.”
Nevertheless, Deverell notes that such large funds can’t fully access some of the interesting secondary properties. He argues that, while prime properties do well initially, those in the £5m to £10m bracket tend to do well in the secondary phase of a property upturn.
Deverell said: “We are looking closely at the Kames Property Income fund – this invests in these smaller properties and could be a very interesting fund now the property upturn is well established. The only issue we have with it at present is that, because it’s growing, it has more cash in the fund than we would like to see.”
Interestingly, the larger property funds instil far less fear in investors than the smaller funds do.
Deverell says that his team likes Aberdeen Property Trust, which is the second largest in the sector at £3.3bn. He adds that he is comfortable with the fund’s size.
He added: “Because of their size, they can access large properties and they can absorb cash inflows as they come in without diluting returns.”
Darius McDermott (pictured), managing director of Chelsea Financial Services, says the most important question when it comes to property funds is how they are using their cash, not how much they have attracted.
He said: “There’s been big flows into property funds for a couple of reasons. Not only does the asset class seem sound on its own, people have been investing for an income and to have some diversification away from fixed interest.”
“With property, the big question for me is: ‘what are their cash weightings?’ It’s important to make sure the fund doesn’t just invest in poor quality properties so that they can get some of that cash weighting invested.”
McDermott’s favourite property fund is Henderson UK Property - the porfolio that Metcalfe has sold. At £3.16bn, it is the third largest fund in the property sector. The fund has an FE risk score of 24 and a yield of 3.6 per cent.
He explained: “Henderson has always had a bias to quality property. It’s certainly got a southern bias and they tend to look for properties that have got good tenants with long leases.”
“One of the main things we always do is monitor their cash weighting. I saw them at a conference a few weeks ago and their cash weighting is about 14 per cent, which is not bad at all.”