Investors should be very cautious on buying direct commercial property funds following their strong returns and the huge amount of money that has flooded into the asset class, according to City Financial’s Mark Harris, who likens its surge in popularity to the hysteria surrounding gold in early 2011 prior the collapse in the price of the precious metal. 
Investors have been told on a number of occasions about the need for alternative assets within a portfolio, largely due to the distorting effects that central bank policies such as ultra-low rates and quantitative easing have had on mainstream securities like bonds and equities.
This stimulus has pushed up the valuations on both bonds and equities which have, in turn, led to increasingly positive correlations between the two asset classes.
For example, when gilt yields began to spike in April this year it led to a fall in the UK equity market. While government bonds have provided a hedge for investors against the recent equity market rout, many warn that when interest rates to start to rise, both equities and bonds will sell off once again.
Performance of indices since April 2015
Source: FE Analytics
This has led to a significant rise in the popularity of direct UK commercial property funds. While they left many investors with psychological damage during the financial crisis, the fact they offer a decent yield, can generate a growing source of income and (most importantly) are traditionally very lowly correlated to bonds and equites is deemed attractive.
However Harris, manager of the various City Financial multi-asset funds, is nervous about this trend given that commercial property is highly illiquid and that its surge in popularity is akin to past bubbles that subsequently burst.
While he understands this need for diversification, he says investors need to know the risks they are taking.
“We are looking much more at alternatives now and trying to generate a return which isn’t directionally biased on equity and bond markets. I guess that’s why most people, in those terms, bought property funds,” Harris (pictured) said.
“We’ve got a little bit in German property, but that’s about it, while most people have taken big positions in UK property.”
Investors have certainly been upping their exposure to commercial property funds.
According to FE Analytics, three of the top 20 best selling funds in the Investment Association universe focus on the asset class – namely Henderson UK Property, L&G UK Property and the M&G Property Portfolio.
While these figures include capital gains, FE data shows the five largest ‘bricks and mortar’ funds in IA Property sector have seen their AUMs, on average, increase by a hefty £1.92bn over the past three years.
Source: FE Analytics
It’s understandable that property funds have proven to be so popular over recent years given their performance.
Since the ‘taper tantrum’ of May 2013 when the US Federal Reserve first mentioned it was looking to reduce quantitative easing, the average direct UK commercial property fund has returned 32.85 per cent, meaning it has outperformed the Barclays Sterling Gilts index and the FTSE All Share by 21 and 27 percentage points respectively.
Performance of funds versus indices since the ‘taper tantrum’
Source: FE Analytics
As the graph shows, those returns have been generated irrespective of what has happened to equities and government bonds. It must be pointed out, however, that those funds are priced far less regularly than the two indices – and that is why Harris is concerned.
During the global financial crisis when property prices began to tank, the open-ended nature of unit trust and OEICs meant fund managers didn’t have to underlying liquidity to meet their unitholders’ redemptions.
As a result, some investors were effectively locked in their funds and incurred hefty capital losses as a result.
Harris therefore says investors need to be aware of the risk they are taking by buying into property funds now they have performed very well and have already taken on a lot of money.
Harris said: “The risk with property funds, as we all know, is liquidity. If people do think, ‘it’s all done and I want to get out’, that could be interesting.”
“I always find it fascinating, and it’s just a casual observation, whenever money is just flowing into one area and it’s described as the ‘no-brainer’ investment or the ‘obvious trade’ – that’s often close to the peak.”
He says there are a number of examples in the past where investors have flooded into an asset class at completely the wrong time.
“Earlier in the year in Europe when Mario Draghi was talking about QE and you had the top percentile of fund flow into European equities from the US, guess what? That marked out, more or less, the top of the market.”
He says, although not as catastrophic, that the popularity of property funds is similar to the huge demand for physical gold in 2011. He points out that there were adverts in the mainstream media for people to hand in their gold for cash, but little did they know the gold price peaked in September and is down 35 per cent since.
Performance of index since Jan 2011
Source: FE Analytics
Harris added: “Just have a bit of common sense as it goes a hell of a long way, a hell of a long way.”
All in all, the manager – who has narrowly beaten his peer group composite since he took charge of the City Financial multi-asset range in January 2013 – admits that he should have had more in property over recent years, but questions why investors would buy now.
“In a way, maybe I should have put more in property funds on reflection given I had a very low interest rate view. That would have supported their yields and valuations, but it’s a bit late for me in the UK.”
Harris isn’t alone in being concerned about the surge in demand for property funds, with F&C’s Gary Potter labelling the trend “staggering” in an article earlier this year, cautioning investors to remember the devastating losses that hit the asset class at the peak of the financial crisis.
“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,” he said.
“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.”
