Jeff Salway: Commercial property recovery must be viewed with caution

RUSHING to beat the end-of-tax-year Isa deadline may be a flawed investment strategy, but evidence suggests people have done so in record numbers over the past two months.

And not only have many investors piled in oblivious to the importance of long-term, drip-drip savings, there are also signs of a return to the faddish activity that has characterised previous Isa seasons.

Commercial property has been the biggest theme in fund sales of late, coming top of the Investment Management Association's best sellers list for four consecutive months. But the resurgence of commercial property is curious and, for investors banking on bricks and mortar to stand firm in its recovery, there is cause for concern.

Certainly, values have recovered about 10 per cent of the value lost in a 45 per cent slump in the two years from July 2007 that wiped out most of the gains in the four years up to that point. That sharp decline spooked so many investors that commercial property funds were forced to close the exit routes to prevent withdrawals draining the cash from their funds.

Those investors had piled into the asset class in the mid-noughties in search of unusually high returns, even though commercial property has always been more of an income and diversification play.

This time, however, income is the big commercial property selling point for investors, along with low valuations. With savings returns in short supply, the search for income has moved up a risk level or two and commercial property funds – currently yielding between 6 and 7 per cent – have been the biggest beneficiaries. Overseas investors have also returned to UK commercial property, attracted by the weak pound.

But as commercial property funds watch the money flow back in, there are still big question marks over the fundamentals and the possibility that this is a short-lived revival must be a realistic one.

The prospect of further increases in unemployment and insolvencies over the next year as interest rates rise again and spending cuts bite could put the brakes on the rental growth that the market needs to sustain its recovery. If the rise in insolvencies does materialise, then it will further weaken tenant demand and soften support for rental prices.

Similarly, as government support for banks is gradually withdrawn, tenants coming to the end of loan deals will find it increasingly difficult to secure new finance, posing a further threat to demand. In short, conditions in the commercial property market will remain challenging for as long as the economic outlook remains uncertain.

Even commercial property fund managers talking up the sector are careful to highlight the risks posed to investors. Don Jordison, head of UK commercial property at Threadneedle, warned on Tuesday that government spending cuts would have an impact on the amount of space occupied by a number of agencies and departments. On top of that, much of the impaired property-related debt currently held by the banks is likely to be put back on the market as pricing improves, said Jordison. He is far from alone in pointing out that downward pressure on prices would intensify should the banks start selling the property they acquired as a result of loan defaults,

The good news for investors, according to Jordison, is that despite the medium-term uncertainty over capital returns, commercial property will resume its traditional role as an income-driven and income-producing asset class.

But the numbers in which investors have piled back into commercial property in recent months suggest that many expect a return to the double-digit growth of the mid-noughties. They are likely to be disappointed and for those investors in the sector for the right reasons – income and diversification – that makes it even more important to pick the right fund.

A correction in commercial property values could trigger a repeat of the large-scale withdrawals that forced so many funds to slam the doors on departing investors two years ago, when those funds without sufficient cash to cope with a sell-off suffered most.

Most funds have between 5 and 10 per cent in cash, although there are exceptions, with the New Star UK Property fund currently holding more than a fifth of its portfolio in cash.

Finding the middle ground is increasingly important for investors – too much inhibits performance, but in the event of another collapse in values those funds without sufficient liquidity will be in trouble.