Direct commercial property funds are still the best bet for investors seeking alternatives to bonds, according to Whitechurch’s Ben Willis, but he warns investors shouldn’t expect their recent stellar gains to be repeated.
Property funds had been among some of the most hated in the Investment Association universe owing to their performance during the financial crisis, as the combination of plummeting capital values and mass redemptions meant many investors were effectively locked into some portfolios due to the illiquid nature of the asset class.
According to FE Analytics, the IA Property sector (which encompasses both direct and indirect property funds) fell more than 30 per cent between 2007 and 2010 while equities were down 3 per cent and bonds made a positive return.
Performance of sector versus indices during the global financial crisis
Source: FE Analytics
Despite that, ‘bricks and mortar’ funds have become increasingly popular over recent years thanks to an improving economic backdrop and as investors have looked for alternatives to bonds, which have offered historically low yields and potential for large drawdowns if interest rates start to rise.
This means the average UK property fund delivered gains of close to 20 per cent last year but with more and more investors jumping on the bandwagon, causing many managers to have to stockpile their un-invested cash, many experts have warned the market may be overheating.
Willis, head of research at Whitechurch, doesn’t agree though and has taken the decision to up his exposure over recent weeks.
“We did some research and risk analysis into property funds recently,” Willis explained. “We have had good access to property managers over recent years as we went back in quite early after the crash and re-allocated to them in Q4 2009.”
“We originally bought back in as property funds offered an attractive yield and could act as a diversifier. Ever since then the returns have been good and following our analysis, we have taken the decision to increase our exposure within our portfolios from 15 per cent to 20 per cent.”
He added: “We have done that by adding a new property fund to our portfolios.”
Property funds have certainly performed well over recent years, especially since the ‘taper tantrum’ in May 2013 when the US Federal Reserve warned markets that it would begin reducing its quantitative easing programme and sparked a pan-asset class sell-off.
Over that time, FE data shows the average direct property fund has outperformed the FTSE All Share, Barclays Sterling Gilts index and the iBoxx Sterling Corporates All Maturities index with returns of 17 per cent.
As the graph below shows, while they are often priced less frequently than bonds and equities, property funds have also delivered far lower drawdowns over that time.
Performance of sector versus indices since the ‘taper tantrum’
Source: FE Analytics
This performance, the yield available from them and the increasingly negative outlook for traditional fixed income has meant more and more investors have allocated to property funds over the last year.
In fact, three of the top 20 best-selling open-ended funds over the past year focus on direct commercial property.
This has caused an issue in itself, however. Given the illiquid nature of buying and selling buildings, property managers who have seen huge inflows have had to park a high proportion of their assets on the side lines – potentially diluting future income and total returns which investors bought for in the first place.
FE data shows the average bricks and mortar fund holds 10 per cent in cash, though popular vehicles like Standard Life UK Property and L&G UK Property have more than 25 per cent in the money market.
These trends, along with the ever-increasing popularity of the asset class, have sparked concerns among leading industry experts such as F&C’s Gary Potter.
“Frankly I’m staggered – and I know that’s a strong word – by the euphoria that’s surrounding property once again. I think there are some good opportunities in property but if you look at what happened the last time you had this much cash going into commercial property funds, it wasn’t good. That really scares me,” Potter said.
“I just wonder why people don’t think more about what happened in 2008 with the large retail-focused property funds. Now you’re getting potential cash drags and ever larger properties being purchased because the funds are so much bigger.”
“I think people have forgotten the not-too-distant memory of 2008 when property funds generally fell 40 per cent. I’m not suggesting for one minute that the economic conditions akin to 2008. But what I am suggesting is that the elastic has been stretched too far between price and fundamentals here.”
However, Willis says investors can still feel comfortable buying into the sector – with the caveat that they shouldn’t be doing it in the expectation of 20 per cent gains, which was the case in 2014.
“We’ve been sensible. We have been using it purely as an alternative to gilts. We weren’t expecting property funds to deliver halve the returns they have and we don’t expect those sorts of gains going forward,” he said.
“You’ve got to look at property for what it is, an income play. Any other returns should come from rental growth. The point is that when bonds and equities sell-off, property can act as a diversifier.”
Willis currently uses the Henderson UK Property OEIC, which gives him exposure to core London and south-east markets, the M&G Property Portfolio, which has a slight regional bias, and the Threadneedle UK Property fund, which is slightly higher yielding due to its focus on secondary properties.
To add to that mix, the head of research has bought the Kames Property Income fund, which is slightly higher risk due to its weighting to the north of England and its bias towards smaller allotment sizes.
Performance of fund versus sector since launch
Source: FE Analytics
Since its launch in March last year, the £280m Kames fund – which yields 4.9 per cent – has outperformed the average ‘bricks and mortar’ fund in the Investment Association universe with returns of 10 per cent.
It has an ongoing charges figure of 0.95 per cent.
