A deteriorating outlook for UK commercial property means bricks and mortar funds are likely to suffer large drawdowns over the short to medium term, according to Hawksmoor Investment Management, which has completely sold out of the £4.8bn M&G Property fund within its Model Portfolio Service as a result. 
Up until recently, money had been gushing into direct commercial property funds for a number of years.
The reasons behind this trend are relatively simple. Firstly, the UK’s economic landscape has improved while, at the same time, investors have been forced to look outside of the bond market for a reliable income stream and low correlations to equities.
Thanks to a pick-up in economic activity and the sheer demand for asset class’s income characteristics, UK commercial property funds have been among the best performers in the whole Investment Association universe over the past three years.
Indeed, FE data shows the average fund in the mini-peer group has more than doubled the returns of gilts and UK equities over that time.
Performance of funds versus indices
Source: FE Analytics
However, as mentioned earlier, that trend has (albeit tentatively) started to change. Property funds are currently in the red over 2016 so far and the IA Property sector has now seen net outflows in each of the last three months.
Hawksmoor Investment Management has now joined the party, having just completely sold its holdings in one of the sector’s heavyweights – Fiona Rowley’s M&G Property Portfolio.
“We decided yesterday to sell the remaining positions in M&G Property Portfolio in the models that held it, having gradually reduced the weightings over the past few months,” Hawksmoor said.
The team at Hawksmoor have been happy with the fund’s performance over the medium term – having used it since 2012. As such, the main driver behind its decision isn’t due to Rowley or the portfolio itself, but more because of its concern about the outlook for the asset class in general.
“The reason behind the disposal is the deteriorating outlook in the UK commercial property market after seven years of strong returns,” the team said.
“Open-ended property funds are particularly sensitive to changes in investors’ sentiment where ongoing inflows support the prices of the property market, but conversely outflows could cause a reversal in this trend and recent data suggests outflows in 2016 have exceeded inflows for the first time in many years.”
Monthly fund flows (in £m) into IA Property over 1yr
Source: The Investment Association
The chart above shows fund flows into the IA Property sector over the past year, highlighting that £170m has been redeemed from the peer group in 2016.
It must be noted, however, that asset class saw a huge amount of money pour in the year before. Indeed, while £170m has flowed out over the past three months, £290m flowed into the peer group in July 2015 alone.
Indeed, the sheer weight of cash had an effect on the sector’s performance profile as, due to the illiquid nature of the asset class, managers were hit by a cash drag which, in turn, caused income pay-outs within the sector to fall off a cliff in 2015.
Income pay-outs from IA direct commercial property funds
Source: FE Analytics *figures based on a £10,000 investment in January 2011
Nevertheless, Hawksmoor warns that if those outflows start to gather pace, it could have a very negative impact on the sector.
“To reflect the high transaction costs for property funds, open-ended funds typically have a large bid/offer spread and have the ability to swing the pricing basis to offer or bid depending on the trend of fund flows,” Hawksmoor said.
“For the last few years positive flows have kept funds on an offer basis, but we fear that the recent change in trend could result in a swing to a bid basis which can result in a fall in the unit price of between 5 and 7 per cent.”
Indeed, just his week both Henderson and M&G have changed the pricing basis of their property funds from an offer to a bid basis thanks to net fund flows.
Michael Stanes at Heartwood, however, believes that Brexit uncertainty could well be the catalyst for this reversal as it will put pressure on prices for the time being.
“In the coming months, we would expect a period of subdued activity as overseas investors wait to see how the referendum campaign evolves,” Stanes said.
Hawksmoor thinks there could be a number of reasons why investors may continue to take their money out of property funds and therefore create falls in unit prices. The group, as a result, advocate avoiding commercial property for now.
“While we believe that property is an attractive asset for investors on a long-term view, as active managers we believe now is an appropriate time to remove the allocation until the outlook improves. The allocation has been switched into either bond, equity or absolute return funds or a combination of these, while maintaining the risk and income profile appropriate.”
Recent surveys show that M&G Property is one of the most commonly used funds among DFMs and wealth managers and, though it has narrowly underperformed against the average IA direct commercial property fund in existence today since Rowley became manager in January 2013, it has made 34.75 per cent over that time.
However, strong appreciation in its unit price has had a big impact on its dividend yield, which has fallen from 4.77 per cent in mid-2014 to its current level of 3.94 per cent.
M&G Property’s published yield
Source: FE Analytics
A number of other industry experts have been bringing down their exposure to property of late. One of those is Justin Onuekwusi, lead manager of the L&G Multi-Index range, who (having been a long-term bull on UK property) has and will continue to reduce his weighting to it within his portfolios.
“UK property, for us, has been one of the most attractive asset classes from a risk-adjusted return perspective. However, we now expect going forward that the abnormal returns we have seen are effectively over,” Onuekwusi said.
However, though Onuekwusi has been reducing his overweight, he sees no reason why investors should ditch property funds altogether within their portfolios.
“We are going to see normality in those returns, say the 5 to 6 per cent level over the next few years. With that, it makes sense to reduce our overweight,” Onuekwusi said.
“However, I think it is important to note that we don’t think the property market is going to crash. There are some important supports in the property market.”
“Construction is at the lowest level it has been since the 1980s (especially outside of London), rents continue to increase especially in the industrial and office space and, last but by no means least, it still offers that diversification from equities and bonds whilst still offering a decent yield.”
He added: “With bond yields being so low, we think that is particularly important.”