The key to reducing investment risk is diversification (the opposite of having all your eggs in one basket), and that means most investors should be looking at property funds, as well as considering direct investments.
Unless you have a very large sum to invest, it would be very hard to build up a well-diversified portfolio of individual properties, especially if you went for commercial property rather than residential. Holding individual properties means that you are exposed to their individual circumstances, including issues with tenants and the local property market.
By contrast, property funds – where you entrust your money, along with thousands of other investors into the hands of a fund manager – provide ready-made diversification through a range of holdings. You can opt for generalist funds to give broad exposure or build up a portfolio of more specialist funds to play niche areas of the property market.
Another significant advantage of using property funds is that all the work is done for you by professional managers. You do not need to take investment decisions, nor do you need to deal with the hassle of purchasing and maintaining properties, or dealing with tenants and bills.
In addition, it is much easier to hold property funds than it is to hold direct properties. Direct residential property cannot be held in pensions (with a couple of exceptions), nor can it be held inside tax-free individual savings accounts (Isas). Commercial property can be held in a self-invested personal pension (Sipps) but, apart from the problem of diversification, you also run liquidity risk, as it could be hard to sell a property when you want to convert your pension into a retirement income.
By contrast, most commercial property funds can be held inside Isas, allowing you to take advantage of your annual £7,200 tax-free allowance. You can hold commercial property funds in personal pensions and any property fund can be held inside a Sipp, whether commercial or residential.
Commercial property funds
Most independent financial advisers (IFAs) favour using commercial property as a portfolio diversifier, instead of residential property investments. This is because residential property is already the largest single asset most people own, through their own homes.
A wide range of funds has sprung up to cater to demand from both institutions and individual investors, who have been attracted by the strong returns from commercial property and are trying to diversify their portfolios away from equities. Indeed, property funds were the most popular fund choice for private investors during the 2006-07 tax year, according to the Investment Management Association, making up 40 per cent of net sales.
Justin Modray of IFA Bestinvest says investors should view commercial property as an income-producing diversifier, rather than a source of capital growth. He warns: "There's been so much yield compression that there's not much further that it can go. It's not necessarily a bubble that will burst, but it's very unlikely to be as exciting as it's been in recent years."
Patrick Connolly of IFA Towry Law JS&P adds: "We don't try to predict asset classes – we don't think anyone can get the timing right – so we hold constant weightings in our clients' portfolios, typically around 20 per cent."
Funds take exposure to commercial property in two ways – and sometimes in both. They can either hold commercial property directly or invest in property-company shares.
Property-company shares have outperformed direct commercial property in recent years, but they offer less diversification from stock markets than direct commercial property exposure. Over the past seven years, property shares have had a 63 per cent correlation with the FTSE All-Share index, whereas direct commercial property's correlation with the stock market was just 23 per cent.
Therefore, a stock-market crash would be likely to hit funds holding property shares much harder than a direct property fund. To some extent, this is a liquidity issue, as buildings are only revalued occasionally or when they are actually sold. What's more, the commercial property market would suffer in a serious economic downturn, as businesses may go bust and leave buildings vacant.
On the other hand, property shares can be bought and sold easily, allowing fund managers to switch holdings around to play market trends. This also means managers can sell holdings to move into cash to protect against market falls or to pay redemptions.
By contrast, it is difficult for direct property fund managers to sell holdings quickly, which makes it hard to respond to market trends. Worse still, if lots of investors wanted to cash in their holdings at the same time, the fund managers might have difficulty selling buildings quickly enough and so might have to limit redemption.
Closed-ended funds
There are two main types of fund structure: open-ended or closed-ended. Closed-ended funds include investment trusts, real-estate investment trusts (Reits) and property funds traded on the Alternative Investment Market (Aim).
The closed-ended structure makes life simpler for fund managers, as they do not have to deal with inflows and redemptions (avoiding forced selling in a falling market). Closed-ended funds can also be geared up (borrowing to invest) to boost returns, although gearing exacerbates losses in a falling market.
The major downside of the closed-ended structure is that a fund's shares can trade at a discount or a premium to their true net asset values (NAVs). A widening discount could cause a double whammy in a falling market, although the reverse is true in a rising market.
Open-ended funds
Open-ended property funds can be held in Isas, personal pensions and Sipps. Some offshore open-ended funds use gearing and limited redemption periods, giving them some of the benefits of closed-ended funds.
Again, the market is split between funds that hold property directly and those that hold the shares of property companies. You can also choose between funds that offer exposure to UK commercial property and funds that offer international diversification.
Geographical diversification could help reduce risk and could also boost income yields. Managers may also be able to spot markets with more potential for capital growth than the UK. On the other hand, it is hard for direct property funds to switch holdings quickly, so managers would find it hard to respond to short-term trends.
As an alternative to an actively managed fund, you could opt for a tracker fund, which should perform in line with an index (gaining exposure through derivatives) and should have substantially lower charges. CF Bespoke IPD UK Monthly Property Index Tracker is the only open-ended fund option. It can be held in Sipps and self-select Isas.
Investment trusts
The property investment trust sector has ballooned lately, with a variety of generalist and specialist funds coming to the market. Several trusts have used offshore domiciles to enable them to pay out gross dividends – dividends from onshore trusts (and open-ended funds) suffer an immediate and unreclaimable 10 per cent tax hit.
Demand for property investment trusts was such that most trusts in the sector were trading on premiums – however, many trusts have now moved to discounts. This demonstrates the risk with investment trusts, as a falling share price can offset any gains in net asset value.
Even so, Mick Gilligan, of broker Killik & Co, prefers using closed-ended funds to take direct exposure to commercial property. "The open-ended structure is wrong – some of these could run into trouble in years to come," he says. You can always sell shares in an investment trust, but you could find yourself trapped in an open-ended fund if the manager was forced to impose a notice period for redemptions.
There are also two UK-listed exchange-traded funds (ETFs) that track property indices: iShares FTSE EPRA/NAREIT UK Property Fund and iShares FTSE/EPRA European Property Index Fund. ETFs are low-cost trackers and are not subject to stamp duty, unlike investment trusts.
ETFs are not at risk from widening discounts, either. You can trade them instantly and could use contracts for difference (CFDs) or spread bets on them to go short (or long), allowing you to hedge other property investments or speculate on a fall (or rise) in prices.
Both investment trusts and ETFs can be held in Isas and Sipps.
Aim-traded funds
Several property funds have also floated on Aim to take advantage of looser listing rules. These funds are like investment trusts, but tend not to be well-covered by analysts, which could throw up some opportunities for canny investors.
Unlike many Aim shares, Aim-traded funds are not eligible for any tax breaks. They can be held in Sipps, but not in Isas (unless the fund has a full dual-listing overseas).
Reits
Real-estate investment trusts (Reits) are property companies that have converted into quasi-funds. They are tax-efficient, but they could be more risky than other property funds.
In return for paying out most of their income, rather than reinvesting it, they avoid having to pay any underlying corporation tax or capital gains tax so all tax is paid by the end investor. Furthermore, the 10 per cent tax on dividends can be reclaimed by Isas and Sipps. This is a big advantage over most other property funds, although it was announced in the last Budget that this tax treatment could be extended to level the playing field for all property funds.
Reits are still managed as property companies so there could be a higher risk than with standard property funds. For instance, a management decision to expand in a new direction could backfire. Nine UK property companies took on Reit status when the rules were introduced in January and more have been launched since then, including Reits offering specialist exposure to local retailers and hotels.
Residential property funds
Homeowners already have a high exposure to residential property. However, your own home may not be considered an investment, as you live there. What's more, your own home is only a single holding in the residential property market and is subject to individual risks. The £3,500bn residential property market dwarfs the £650bn commercial property market in the UK and residential property has a much lower correlation with shares than commercial property – 12 per cent over the past seven years.
Even if the residential property market as a whole stagnates, there could be strong growth opportunities in growing niche areas, such as student halls and retirement flats. Naomi Heaton, of London Central Portfolio Property Fund, says prime locations in central London should do particularly well due to limited supply and London's strong growth, boosted by the 2012 Olympics.
There is a growing range of generalist and specialist residential property funds to choose from, most of which employ gearing. You can also use ground rent funds and strategic land funds as ways to take exposure to current or future residential property developments. Residential property funds can be held in Sipps but not (yet) in Isas. These are unregulated funds so must be bought through IFAs.
As an alternative to an actively-managed residential property fund, you could use open-ended derivative-based tracker fund CF Abbey House Price Plus, which can be bought through Sipps and self-select Isas.
