- Demand for property reflects investors' hunt for yield
- Two main options: direct and physical routes into property
- Funds gain interest on back of high trust premiums
Commercial property was one of last year's bestselling assets, with over £3.8 billion pouring into open-ended property funds in 2014 - the most the sector has taken in a 12-month period for more than 10 years.
Property investment trusts have also seen increased demand, with share price premiums to net asset value (NAV) rocketing to over 10 per cent for the most popular trusts and appetite for the asset class showing little sign of waning.
Increased demand for property is largely the result of investors' current hunt for yield, as commercial property continues to pay an attractive income in the present low interest rate environment.
However, this is putting pressure on prices: both physical property and property securities (shares in property companies) currently look expensive compared to long-term averages.
As Mark Meiklejon, investment director of real estate at Standard Life Investments, observes, higher prices are doing little to deter investors from pouring into property.
'We have seen continued very strong flows into real estate on a global basis as, despite valuations, relative to any other asset class, property looks extremely good value from a yield perspective,' he says.
'Historically, in developed global markets you would see something like a 2 to 3 per cent yield gap between the best-quality real estate and government bonds, and in a lot of markets you're seeing that gap at 3 to 3.5 per cent at the moment,' says Meiklejon, adding that Standard Life Investments' overall house view on property is weighted as 'heavy'.
Having said this, Meiklejon acknowledges that with the Federal Reserve poised to hike US interest rates this year, developed market government bond yields can only go up from here, making property less attractive - particularly as valuations are already high.
However, he insists that as rates are likely to go up only incrementally, and as property supply is still weak, the asset class should continue to remain attractive in the medium term.
Alan Higgins, chief investment officer at Coutts Bank, echoes Meiklejon's sentiments. 'The Coutts perspective on the property backdrop is positive; income streams are in demand, the wider UK economy is performing robustly and interest rates are low.
'While rates are likely to go up soon, it's not enough to derail the decent momentum we're seeing in property nationwide now,' he claims.
REAL VERSUS SECURITY
There are two main investment routes into commercial property: via direct investment in physical property (so-called 'bricks and mortar'), or through the shares of property companies. Few private investors have the means to invest directly in large commercial buildings, which means that most tend to invest in physical property via funds or trusts.
Shares in property companies are more accessible, but many investors still prefer to access property equities through funds, which provide ongoing monitoring, diversification across a number of companies, and cost benefits.
How do the two routes compare? As an asset class, direct property is less correlated to the stock market, which has long been one of its main selling points as an alternative investment. Conversely, property securities will move up and down with wider equity markets, making them more volatile.
Direct property is favoured for its reliable income stream, which is generated through the rents paid by the occupants of the buildings invested in - generally office and retail premises - while securities offer strong capital growth potential.
Whether direct property or property equities are more suitable will depend largely on your objectives; if capital preservation, a steady income stream and diversification away from mainstream securities are your aim, then direct property may fit.
If you're looking to capture capital growth at a sector level, then securities may be better. It's also worth noting that securities are more or less the only option for global property exposure. In terms of risk, direct property is less liquid than securities whereas securities are easier to trade.
The latter point is an important one to bear in mind considering the cyclical nature of the asset class - which means that it has regular peaks and troughs, or cycles, that are usually linked to wider economic factors. Most commentators are of the opinion that we are nearer the top of the current property cycle than the bottom - with an interest rate rise likely to mark the turning point.
This - combined with toppy valuations - is why Mona Shah, senior research analyst at Rathbone Asset Management, doesn't recommend investors get into property at all right now. 'There has been a wall of money flowing into the property sector recently and consequently we do not believe that current yields reflect the risks investors are being asked to take. We wouldn't encourage people to buy at this level,' says Shah.
If pushed, however, Shah says she prefers real estate investment trusts, or Reits, to other vehicles. Reits are closed-ended funds that invest directly in income-bearing properties and carry certain internal tax advantages, while the main attraction for investors tends to be higher yields.
Although numerous in the US, Reits are as yet few and far between in the UK, but Money Observer Rated Fund Custodian Reit is one option. Launched in 2014, Custodian has a well-diversified portfolio of UK commercial properties with a focus on smaller, higher-yielding buildings outside of London.
Custodian currently yields 4.9 per cent with a prospective yield of 5.8 per cent by early 2016 - a particularly attractive prospect for income seekers. However, like all property investment trusts at the moment, this yield comes at a cost, with Custodian's shares trading at a 5.9 per cent premium to NAV as at 30 June. This is at the cheaper end of the closed-ended scale, with the average direct property trust trading at an 8 per cent premium to NAV.
One of the most popular is F&C Commercial Property, which delivered close to 25 per cent in share price returns in the year to 30 June - characteristic of a solid property trust that outperforms in down markets. Unsurprisingly, it is also one of the most expensive, with shares trading at more than 12 per cent above NAV as at 30 June.
Alternatively, Schroder Real Estate is significantly cheaper, with shares at a 1 per cent premium, while its performance over the past three years has improved markedly. Both trusts pay an annual yield of 4.2 per cent.
For those interested in property securities, investment trusts offer potentially better value, with the best performer - Money Observer Rated Fund TR Property - trading at a 1 per cent discount as at 30 June. Launched in 1996 and delivering 173 per cent in share price returns in the 10 years to 30 June, TR Property has a UK and European focus and invests in both equities and physical UK property.
Its only stablemate in the AIC property securities sector, Schroder Global Real Estate, is trading at a deeper discount of 5.4 per cent as at 30 June, which reflects the trust's weaker long-term performance and global focus.
With property trust premiums running at such high levels, many investors are choosing to invest in direct property through open-ended vehicles instead. Traditionally this has been the less favoured route as, due to the illiquid nature of the asset class, property funds have to hold a lot of cash to fund potential redemptions (typically around 15 per cent).
A large cash weighting tends to drag on performance and is why open-ended funds have tended to underperform closed-ended property vehicles, where the sale of shares does not impact on underlying assets.
However, property funds are increasingly proving their worth in what has become a crowded marketplace, particularly over the past 12 months. The best UK-focused direct property performers include Threadneedle UK Property and L&G UK Property, which have returned 12.7 per cent and 12.4 per cent respectively in the year to 30 June.
UK funds invested in property equities have fared even better, with Aberdeen Property Share - a favourite of Alan Higgins - returning close to 20 per cent over the same period.
The high transaction costs associated with real estate means investors in property funds pay larger bid-offer spreads to access these less liquid portfolios. A lower-cost alternative is property exchange traded funds (ETFs), which invest by tracking both property indices and physical property through Reits.
Their ongoing charges figure of less than 0.5 per cent helps offset the impact of wider spreads. iShares offer some of the more mainstream options, including the iShares UK Property Ucits ETF, which costs just 0.4 per cent a year and is the best performer in the Global ETF Property Europe sector over one, three and five years to 30 June.
Routes into commercial property are many; however, as Higgins observes, none are without their drawbacks. 'It is frustrating because property is a very attractive asset class, but the ways of playing it make it expensive,' he laments.
This difficulty is compounded by the fact that the sector may be heading for a trough, meaning that investors should think carefully about why they want to invest in the asset class, how much they want to put in, and for how long.