Large property funds often used to be described as being "as safe as bricks and mortar". But that was before 2008, when several funds were suspended because they could not meet large redemptions when the underlying commercial property slumped and liquidity dried up. Now, though, it seems as if every fund manager is turning bullish on this sector again. I was lately unlucky enough to sit through a long video from one manager who proudly recounted his investment of hundreds of millions into various sites without once mentioning their yields.
Somehow, investors always seem to forget that the long-term performance of property funds have generally been worse than those for equity markets. When a fund gets an inflow of new cash from investors, the funds often end up lying idle until the right deal can be found. This plainly acts as a drag on returns.
The same is true of the hefty costs of buying and selling properties. One direct property fund cites the example of the 4 per cent stamp duty payable when any commercial property is bought. The same fund charges investors a spread of almost 5 per cent when dealing in and out of its offering. Investors are often fooled into believing that they are going to receive the returns from the growth in commercial property, but end up with far less owing to the hefty costs.
So, how well have the long established funds investing in property - both directly and through property shares - performed compared with UK equities more widely and with government bonds? As the table below shows, the asset class's underlying benchmark - the IPD Property Index - is a misleading guide to actual returns in property. The performance of direct property funds has lagged behind the IPD index, property shares, the wider stock market and even government bonds.
Total return annualised 3 years (%) | Total return annualised 5 years (%) | Total return annualised 10 years (%) | |
|---|---|---|---|
| IPD UK All Property TR £ | 7.60 | 9.93 | 5.82 |
| (ABI) UK Direct Property (Pensions) | 4.52 | 6.37 | 3.16 |
| (ABI) UK Property Securities (Pensions) | 11.51 | 16.40 | 5.35 |
| FTSE All Share TR GBP | 8.81 | 16.36 | 8.62 |
| FTSE Gilts All Stocks TR GBP | 5.49 | 4.46 | 5.29 |
Given this showing, why does everyone think that returns have been so great? A likely reason is a concept from behavioural finance known as 'anchoring'. This is the common human tendency to fixate too heavily on the first piece of information offered - the anchor - when making decisions. In financial markets, the anchor tends to be recent returns and as the accompanying chart shows, these have been stellar since the credit crunch.
Source: Bloomberg
History shows that the best time to invest in this field is when property prices are depressed and property share prices are even more so. Investors then benefit doubly as property prices recover and their discount to their asset values narrow.
We regularly buy property shares via ETFs, but only when the values are low and the average discount to their underlying assets are attractive. The graph below shows the change in the ratio of market capitalisation to the published net asset value for UK property stocks since December 1989. The average discount over this period has been 16.5 per cent, but today these shares actually stand at a premium of 7.9 per cent. In other words, property shares are now already discounting future growth in asset values.
Source: REITA
According to the CBRE, the average property yield at the end of the third quarter of 2013 was 6.3 per cent before costs. But what is fair regarding costs? Taking three major players - British Land, Land Securities and Hammerson - and dividing their administrative costs by their gross rental income over recebt years, these costs were typically more than 20 per cent.
Therefore, if the gross yield of commercial property is, say, 6.3 per cent, then the yield after costs is likely to be closer to 5.0 per cent. According to IPD, 86 per cent of property returns over the last 10 have come from rents from commercial properties, with only 13 per cent from capital value increases.
The warning signs are plain to see. Fund managers are piling in, prices have already gone up a lot, yields are thin, and quoted property prices stand at a premium to their historic asset values. Next time a manager tries to promote his property fund to you, ask him how much of it he's bought himself lately.
Alan Miller is founding partner at SCM Private. Previously, he was one of the City's most consistent top-performing fund managers
