Andrew Wilson: It's too late for the faint hearts to quit property sector

Published on Saturday 26 January 2008 15:48

IT WAS only a year ago that investors were buying commercial property funds in vast quantities, after several years' strong and sustained performance. Some industry 'experts' warned of the dangers of these funds, but they had been warning of these dangers for three or four years during which time commercial property had continued to perform well.

One year on and we are facing an entirely different landscape. The sentiment has changed to one of doom and gloom, with fund prices falling and fund managers imposing additional exit penalties and/or time delays before investors can withdraw their funds.

This scenario has come about in part because commercial property has become far more accessible for investors. This is good news in the long-term, but shorter term has seen the value of property oscillate some distance from fair value and become more volatile. However, rather than being dragged along by short-term sentiment and fluctuations, a sensible investor should be addressing why they want to hold commercial property in the first place.

At outset it is important to differentiate between actual 'bricks and mortar' commercial property and property shares. Many investment funds hold a combination of the two, and while bricks and mortar property consists of real physical buildings, which you are able to touch, property shares are simply shares in property and property-related companies. It is property shares that are more likely to move up and down with the stock market in general and property shares that have suffered by far the worst of the losses over the past 12 months.

Towry Law only holds bricks and mortar commercial property within its client portfolios. This commercial property has excellent diversification characteristics alongside other assets an investor is likely to hold, such as equities and fixed interest, and is a 'real' asset. It entitles investors to a claim on the stream of rental income and a share of the value of the land and buildings. Hence, with a real physical asset, the worst-case scenario is nowhere near as bad as for equities or bonds, which could conceivably suffer 100% loss. What is more, despite recent performance, commercial property has the potential to provide consistent returns for long-term investors.

It is important to recognise that commercial property should be a long-term hold. Because of the costs involved it is not a suitable investment for short-term investors who believe they are able to time markets. Many of these investors are now finding this out to their cost, and given that a large proportion of inflows were at the end of 2006 and beginning of 2007, it appears that their actual timing abilities remain as off beam as ever. Most historic holding periods for commercial property reveal very solid annualised returns, but now we are seeing investors buying high and selling low and taking a 20% loss.

There is also a misconception about the liquidity of commercial property. The issue is rather that property fund managers do not want to be forced to sell their properties at any price. We support this stance, as it would be unfair to the remaining long-term investors. The past few months have seen fewer buyers, in part due to the credit crunch, and as funds are valued at transactional prices, these prices have had to fall significantly in the short-term to reflect this supply and demand, which in turn has led to negative sentiment and a self-feeding frenzy. However, the characteristics of the underlying properties, which often have average 10-year leases and upwards-only rent reviews, haven't changed at all. The equivalent annual yield on commercial property is now more than 6%, which compares well with the 4.5% yield available on a 10-year gilt.

Towry Law supports the property fund managers who are sticking within the remit of their prospectus and protecting longer-term sensible investors. We do not profess to know what will happen to commercial property prices in the short-term. It is conceivable they could fall by another 5% or 10% in the first half of the year before they level out and start to appreciate again. However, there will be a floor as foreign investors, including sovereign wealth funds such as those from the Middle East, will come in, and if interest rates fall enough then leveraged UK investors will also return.

Therefore, for those trying to time the market, if you were going to panic it is probably too late to do so now. There are no prizes for being the slowest moving sheep. These investors should learn the lesson that commercial property is too expensive and bulky an asset class to short-term trade. However, if property is part of a sensibly constructed medium to long-term portfolio then investors need to ride out the short-term noise.

We still believe that commercial property should remain an integral part of client portfolios; it remains an excellent diversifier and has the potential to provide strong consistent returns over the long-term.

Andrew Wilson, head of investments at Towry Law