Happy home for funds

While incomes have increased by 92 per cent since 1995, house prices have soared by 204 per cent, according to the latest Social Trends survey by the Office for National Statistics. In Scotland, house prices have leapt 22.4 per cent in a year, even though the most affordable town in the UK is Lochgelly, Fife where an average house costs 104,738, according to HBOS.

"Bricks and mortar are a good diversifier from equities," says Paul Galloway of IFA Edinburgh Risk Management, who tips New Star Property and Standard Life Select Property funds.

While domestic property fuels front pages, commercial property has quietly been performing well. The Investment Property Databank reveals that last year UK commercial property rose 18.1 per cent, beating both equities (up 16.8 per cent) and bonds (down 0.1 per cent). This followed a 19.1 per cent return in 2005 and takes the three-year annualised return to an impressive 18.5 per cent.

However, the Financial Services Authority is concerned about so much money going into the sector. UK commercial property funds are so popular that Iain Wishart, of Hurley Financial Services in Edinburgh, says rental yields are falling and many funds are holding too much in cash owing to a lack of suitable properties. He warns that in the event of a crash in values, investors may not be able to access funds easily.

Rising interest rates and a general economic slowdown should have the effect of dampening the frothy demand in property. Single rather than double-digit returns may be the norm for the next year or two and new investors should not expect the boom to continue.

Even if property prices may have peaked, property funds have appeal for the reliability of rental income and higher than usual capital growth. Professional advice should be sought, as the term "property fund" covers several different types:

• investment mainly in UK property

• investment primarily in shares of property companies

• investment mainly in foreign property.

Since January there has also been the Real Estate Investment Trust or REIT, which gives smaller investors the more liquid and tax-efficient route into property investment. A REIT is a quoted firm that both purchases and runs income-producing property, whether domestic or commercial. With a REIT, a minimum 90 per cent of its taxable rental income has to be distributed to shareholders as dividends, in return for exemption from capital gains and corporation tax.

Collective funds that invest mainly in bricks and mortar rose 17.9 per cent on average last year, but property share funds jumped 37.9 per cent on average, according to research by Fidelity International.

While in the long-term - 15 years - the returns are broadly in line, expect more volatility from property share funds. The latter are preferred by IFA Iain Wishart, as money can be accessed far more easily and transaction charges are generally lower.

He likes Schroder Global Property Securities, which has about 109 million and is invested in 56 holdings, of which 32 per cent is in the US, 11.5 per cent in Hong Kong and 10.5 per cent in the UK. The asset spread includes investment trusts, equity and debt securities. It has grown by more than 26 per cent in the last year.

Standard Life's Select Property Fund is also tipped by Wishart. Managed by Andrew Jackson, the fund returned more than 28 per cent in the last 12 months and has an excellent long-term track record in managing property-style funds.

"Better potential returns may lie abroad at the moment," says Alistair Blyth of Edinburgh-based ABI Financial Planning. "The newly launched New Star International Property Fund looks attractive."

This fund will typically invest 80 per cent in bricks and mortar with the rest in property shares for liquidity. An income yield of 4 per cent is expected and it qualifies for PEP and ISA status.

Regarding continental Europe, Scottish Widows has a more specialist fund entitled European Real Estate. It came top in its sector for the year to 1 March, although there are only three other European property funds in this sector. Its largest holdings are in the UK, France and the Netherlands. Scottish Widows has a long-established large property team and this fund is managed by Ian Hally.

Those looking for yield - particularly pensioners - should find appeal in this whole sector. REITs are expected to pay out the majority of their income but those based on UK property are not currently cheap. There are specialist funds that aim to take advantage of the global performance of REITs: Franklin Global REIT and Standard Life Global REIT are two. Alex Watt of Standard Life says it may invest in such diverse properties as a German airport operation and a Singapore property development company.

According to a survey by Investment Life & Pensions Moneyfacts, Aberdeen Property Share led the way among property unit trusts over three, five and ten years in terms of return. A 1,000 investment would have doubled in value in three years, while over a decade, the figure has more than quadrupled to 4,185, in comparison with an average 1,883 .

Many of the new fund launches have concentrated on the potential outside mature markets, such as Australia and the US. Instead they are aiming for the "new Europe", such as the Baltic states, Poland and Romania. If these appeal, consult your IFA, and gain their insight into the potential as well as the expertise of the fund manager and their research team.