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Property securities or physical buildings?

Following the recent troubles of funds which invest directly in property should you invest in property securities funds instead?
September 1, 2016

Funds which invest directly in commercial property made headlines for all the wrong reasons earlier this summer, when many stopped investors withdrawing their money following a wave of redemption requests. The move brought home the risks of investing in funds that directly own property – a notoriously illiquid asset. So could investing indirectly in commercial property via funds that hold the shares of property companies, rather than actual buildings, be better?

Open-ended property securities funds invest at least 80 per cent of their assets in listed property companies, and while some will invest their full portfolio in these others put up to 20 per cent in direct property. Adrian Lowcock, investment director at Architas, says the main advantage of property securities funds over direct property funds is that they should always be able to trade their assets. "Because the underlying investments are shares listed on a stock exchange you have a lot more liquidity, as you don’t have to sell a whole property if you need to raise cash," he says.

Colin Low, managing director of Kingsfleet Wealth, thinks the fact that property securities funds trade in listed equities means they are more transparently valued than direct property funds.

He says: "You will probably get a more accurate reflection of what the underlying asset is really worth, because you're getting almost a daily view of what it’s worth. One of the issues that's become more apparent with the bricks and mortar funds is just how often they are valued. Is the daily price a good reflection of what those underlying assets are worth?"

Matthew Riley, head of research at Natixis Global, agrees there are problems with valuations of direct property funds which cause a mismatch between the underlying liquidity of the fund and the liquidity given to investors. As a result, he thinks the risks of open-ended direct property funds are much higher than investors and advisers generally suspect.

"People invest in these funds thinking they are very low risk and they’re going to give them steady returns," he says. "The trouble is that the risk that is reported by the funds is lower than the real risk. We know this because when you value a property you have a portfolio of properties that you own, and you don’t value them every day or even every month. The best industry practice is to value quarterly. Yet these funds set out to offer daily liquidity to investors – so how do they value them? The thing is that they don't.

"There's a lot of smoothing in there and [funds argue] the price doesn't move very much, and even if there is a big move in property values, it takes a few months to be reflected."

Indirect property funds have almost the exact opposite issue he argues, with advisers and investors relying on simple statistics which overstate the volatility risk of holding property company stocks.

For example, when Natixis Global analysed the sector averages for the UK direct property sector and Europe indirect property, which they used as the closest proxy for UK indirect property managers, the three-year annualised volatility of the direct property sector averaged around 2.5 per cent compared with nearly 17 per cent for indirect property.

On these basic statistics, one could conclude that direct property carried only 15 per cent of the risk of indirect property, but Mr Riley says when they analysed the maximum drawdown of both sectors, the risks were much closer.

Maximum drawdown measures the largest single drop from peak to bottom in the value of a portfolio. Natixis's research found that between January 2000 and June 2016, the direct property sector average had a maximum drawdown of 30 per cent versus around 56 per cent for the indirect property sector average.

"On this basis the drawdown risk of direct property is about 55 per cent that of indirect property," explains Mr Riley. "In particular, the risk characteristics of direct property show significant negative skew – meaning downside risk is higher than upside risk."

James Beaumont, international head of portfolio research of Natixis, says given these hidden risks, investors should think twice about how much they put into property funds. Especially as Natixis’s analysis of almost 30 adviser companies’ model portfolios found conservative portfolios had the highest allocation in property.

"Property can be quite volatile," says Mr Beaumont. "It goes up nice and smoothly, and then it has a sudden drawdown as things get revalued. So we're surprised quite how much exposure there is in low-risk portfolios to property – about 10 per cent right now – while there’s only 2 or 3 per cent in high-risk portfolios. We're surprised that's not the other way around. We’re not saying [property] is a bad asset class, we’re just saying some people don't always manage it correctly within their portfolios."

Liquidity is less of a problem for investment trusts which invest directly in property, as these do not have to meet investor redemptions. However, when there are problems in the property market their share price falls and they tend to swing out to very wide discounts to net asset value (NAV), meaning their shareholders may not wish to sell at those levels.

 

Reasons to stay direct

However Sam Lees, head of research at Fund Expert, thinks that direct property funds offer investors better prospects.

"If you are looking for higher yields and less volatility then some areas of the commercial property market are a better bet," he says. "As the exposure you get [with property securities funds] is effectively stock market exposure we prefer to get this through more diversified equity funds and to pick up commercial property exposure through genuine bricks and mortar funds.”

"At the end of the day you’re still getting a fantastic diversifier in property, and it’s a diversifier for income, asset allocation and growth," adds Mr Lowcock. “So it's very good for portfolio construction – putting 5 per cent in property can diversify and protect capital."

And investors' ability to access their money in the event of a market sell-off is not necessarily a good thing as it allows them to panic and sell at the bottom. Property securities funds are also likely to experience more volatility than direct property funds.

Mr Lees believes the sell-off that followed the Brexit vote created a number of interesting opportunities in the property sector and expects upward adjustments in open-ended direct property funds, especially those that focus outside of London and the South East.

"London has suffered from significant yield compression over the last few years as prices have risen and yields have gone down," he says. "So investors looking for yield are better looking at funds less focused on the South East such as F&C UK Property (GB00B6449M48), Kames Property Income (GB00BK6MJF73) and Legal & General UK Property (GB00BK35DT11)."

However he does highlight F&C Property Growth and Income (GB00BQWJ8794), a physical property and property share fund, which may be of interest to investors wanting to combine the two assets in one fund. "The physical property is all UK while the property shares are European," says Mr Lees. "This gives exposure to larger developments like shopping centres that you can't get access to in physical property with small lot sizes."

Overall, though, Mr Lees thinks bricks and mortar property funds tend to offer better diversification from other assets than property securities funds, which are more sensitive to swings in equity market sentiment.

Mr Low agrees that direct property funds offer more diversification than property securities funds, but says that does not mean property share funds do not offer any diversification at all. "They are going to be diversified away from, say, food retailers or oil stocks," he says. "But they are more closely correlated with equities than bricks-and-mortar funds. They are a diversifier but their correlation is not much as if you bought bricks-and-mortar funds."

He prefers using property securities funds which take a hybrid approach to investing such as TR Property Investment Trust (TRY) and F&C Global Real Estate Securities Fund (GB00BG5GMF34).

"Investment trusts are the best way of accessing the sector, primarily because they have a lot more flexibility in what they can do and it keeps liquidity available," says Mr Low. "Although if you’ve got property shares, they should be liquid all the time"

He has also used global property securities open-ended funds for clients including JPMorgan Global Property Securities Fund (GB00B235R373) and Schroder Global Real Estate Securities Income (GB00BDD2DK47), formerly known as Schroder Global Property Securities Fund. He liked their consistency.

Mr Lowcock also rates Schroder Global Real Estate Securities Income. "It's a got a yield of 4 per cent, so it's a much more attractive yield for income seekers, but still has the potential to grow," he says. "Because it's global it gives you access to growing markets, so you don’t have the UK-centric concerns which have basically made property a bit flat in the UK this year."

He also likes TR Property (TRY), an investment trust focused on property securities which was trading at a 12.5 discount to NAV as of 26 August according to Winterflood Securities.

"It’s got five-year dividend growth of 4.5 to 4.8 per cent per year, but the yield is 2.6 per cent," he says. "It's not necessarily going to form a large portion of a portfolio for an income seeker because that is a relatively low yield. But its got a good, strong management team with a lot of expertise in this space."

 

Performance of property securities funds and trusts

Name1-year return (%)3-year cumulative total return (%)5-year cumulative total return (%)
Aberdeen Property Share I Acc-6.031.376.7
Aberdeen European Property Share I Acc8.644.361.2
BlackRock Global Prty Secs Eq Trkr D Acc33.248.386.4
F&C Global Real Estate Securities 3 Acc34.5nana
Fidelity Global Property W Acc26.447.081.3
First State Glbl Prpty Sec B GBP Acc22.545.276.4
First State Asian Property Sec B Acc21.525.959.0
JPM Global Property Secs C Acc9.331.661.1
Premier Pan Europe Prop Share C Acc4.056.988.2
Schroder Global Cities Real Estate Z Acc27.040.067.4
Schroder Global Real Est Secs Inc Z Acc*39.138.961.6
Old Mutual Glbl Prpty Secs A GBP PtH Inc6.530.147.1
SLI Global REIT Plat 1 Acc5.927.154.9
TR Property ord20.070.2102.9
IA Property sector average10.928.041.7
FTSE EPRA/NAREIT Developed TR GBP34.353.395.0

Source: Morningstar as at 30/08/16

 

Direct property funds performance

Fund1-year return (%)3-year cumulative total return (%)5-year cumulative total return (%)
Aberdeen UK Property A Acc-10.615.415.8
Aviva Investors Property Trust 1 GBP Inc-0.618.521.8
BlackRock UK Long Lease Property Inc GBP1.87.6na
BlackRock UK Property £5.436.345.5
Braemar UK Agri Land Cell Ordn A-3.25.924.1
Canlife UK Property Jersey Acc-1.030.787.5
CCLA CBF CoE Property Inc4.847.837.8
CCLA COIF Charities Property Inc4.741.044.6
CCLA Local Authorities Property Inc5.044.945.9
Coast Freehold Income Instl GBP Inc11.934.0na
Commercial Freehold A Gross Acc8.8nana
Darwin Leisure Property C Acc12.138.5111.4
F&C UK Property 1 acc-8.96.110.0
Freehold Income Authorised A Gross Acc9.830.148.2
HC UK Student Accommodation A Acc1.88.8na
Henderson UK Property PAIF A Acc Net-7.113.724.0
Hermes Property Unit Trust4.833.332.6
IFSL North Row Liquid Property A Acc2.2nana
Kames Property Income B Gross Acc-6.6nana
L&G UK Property I Acc1.226.432.6
Lothbury Property Trust4.134.249.4
M&G Property Portfolio GBP A Acc-9.811.315.7
Mayfair Capital Property Inc Tr Char GBP8.947.060.1
Mercer UK High Income I-1£4.522.535.0
MGTS St Johns High Income Property Acc5.217.7na
Royal London Property A Acc5.834.140.0
Royal London Property Trust A Acc5.834.140.0
Schroder UK Real Estate Inc6.445.2na
SLI UK Real Estate Institutional Acc-7.213.3na
St James's Place Property Acc2.525.729.1
TM Hearthstone UK Residential A2.024.2na
IA Property sector average10.928.041.7
Morningstar Category: Property - Direct UK-0.919.823.1

Source: Morningstar as at 30/08/16. *Property funds that have suspended trading are not included as they have stopped reporting their returns data.