As safe as bricks and mortar? Only if you pay the right price at the beginning.

As safe as bricks and mortar used to be the description given to large property funds before several funds were suspended in 2008 because they could not cope with large redemptions when the underlying commercial property market weakened and liquidity dried up.

Now I read that every fund manager is turning bullish and recently I had the mis-fortune to watch a long video from one such manager proudly talking of how he managed to invest £100s of millions into various sites without him ever mentioning the actual yields.

It always amazes me that so many people think that the long-term returns from investing in property funds are great when they generally tend to be worse than equity markets.  This is partly because the costs of buying and selling property are substantial so when money flows into a fund buying direct property it can either mean that the fund returns are a) diluted by holding too much cash or b) diluted by the significant costs associated with buying such properties.   According to one direct property fund, the difference between the buying and selling prices for their fund is currently 4.9% which it attributes to the high costs of buying and selling, including the 4% Stamp Duty Land Tax when any commercial property is purchased.  Investors are often fooled into believing that they are going to receive the returns from the growth in commercial property, but due to these costs the actual returns they receive are much less.

I found it intriguing to investigate the long established insurance funds investing in property, whether directly or through shares, against UK government bonds and equities.  My findings below show that the underlying returns, as shown by the IPD Property Index, are quite illusory.  In fact it shows investors are much better off investing through the property stocks rather than through direct property funds.  Being a cynic, I can’t help thinking that the talented and shrewd property investors are more likely to be found within an entrepreneurial quoted property stock than a sleepy insurance company. Investors would also gain from much higher liquidity and an element of gearing.


So why does everyone think, returns have been so great?  Because of a concept, known in behavioural economics as anchoring.  Anchoring describes the common human tendency to rely too heavily on the first piece of information offered (the “anchor”) when making decisions. In investment, this tends to be recent returns and as you can see, since the credit crunch these have been stellar:


My own view is that you need to be more opportune when investing in property since the best opportunities normally come when property prices are depressed and property share prices even more depressed.  This would mean investors get a ‘double whammy’ on the way up as property prices recover and their discount to their asset values narrow.

We regularly buy property shares (via ETFs) but only when the values are low and the average discount to their underlying assets are attractive.  The graph below shows the change in the ratio of market capitalisation (i.e. share prices) to the published net asset value for UK property stocks since December 1989. The average discount over this period has been 16.5%, but today these shares actually stand at a premium of 7.9%.  This means property shares are now already discounting future growth in asset values.


According to the CBRE, the average property yield at the end of Q3 last year was 6.3%, but this was before costs. The question is ‘what is fair regarding costs’? I looked at three large property stocks, British Land, Land Securities and Hammerson and divided their administrative costs by their gross rental income over the last few years and found that these costs were typically over 20% of the income. So if the gross yield of commercial property is say 6.3%, then the yield after costs is likely to be closer to 5.0% pa. According to IPD, 86% and 81% of total property returns over the last 10 and 20 years respectively have resulted from the rent receivable from commercial properties, with only 13% and 18% respectively resulting from capital value increases.

I do not claim to be a property expert but sometimes too narrow a focus can be a dangerous thing.  Fund managers are piling into this asset, advisers are recommending it, the prices have just gone up significantly, the yields are much less than they used to be and the quoted property prices now stand at a premium to their historic asset values.  The totality of all of these indictors does not sound great to me.

Next time you see a tedious video from a property fund manager telling you to buy their fund, ask if they have bought any themselves recently.


Alan Miller


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