The UK has a longstanding passion for property ownership. According to the Council of Mortgage Lenders, in 2015 there were 11 million mortgaged properties in the UK of which buy-to-let mortgages made up 16.6% of this market.

However, we have seen changes such as cuts in tax relief and increases in stamp duty– all signs that are discouraging people from going into the buy-to-let market. With this in mind, we explore an alternative source of income by investing in a property fund.

 

How Property Funds Operate

There are around 41 funds in the IA Property sector which is classified as a specialist area. Funds can invest directly in properties (also known as bricks & mortar funds), indirectly through shares in companies that invest in properties e.g. Land Securities or a hybrid of the two.

Direct property funds may face liquidity issues as it takes time to sell properties and when there is a downturn in the property cycle, it can make the process more difficult. On the other hand, indirect property funds may have less of a liquidity issue as the shares are traded on the stock market daily. In addition, total returns are determined by share price and dividend income unlike bricks & mortar funds where it is based on rental income and capital appreciation of a property.

Traditionally, property funds invest in mainstream commercial properties, however, in recent times, some fund managers are branching out to alternative propositions such as click & collect warehouses and student accommodation on the assumption that online businesses will continue to grow and there will be increasing shortage of student accommodations.

The Associated Costs with Property Funds

Buying property in a fund will still incur the associated costs such as legal fees and stamp duty – because of this transaction costs are typically more expensive than other asset classes such as equities and will affect the performance of the fund. There is usually a high cash reserve in funds which acts as a buffer for redemption purposes.

However, having the cash available as a source of liquidity means part of the money isn’t invested and so the performance of the fund will also be affected by this.

Most property funds have a dual pricing system where there is a different price to buy and sell shares in a fund. It is often seen as a measure used to protect investors in the event of large redemption requests and fund managers are forced to sell properties within the fund. In this situation, typically, investors will be offered a lower selling price (than the buying price) because it will take into consideration the associated costs in selling the properties to meet redemption. This means the investors who wish to remain in the fund won’t bear the transaction costs.

The Influence of Brexit

Due to the illiquid nature of property funds, fund managers were increasing the cash reserve in preparation for outflows as investors were increasingly requesting redemptions ahead of the referendum result.

Following the results, we have seen a number of fund managers suspending dealing on their property funds due to the unexpected high level of redemptions e.g. Standard Life, M&G, Aviva and Henderson.

Because the funds invest directly in commercial property, when a large amount of investors want to redeem their holding, liquidity can become a concern. Suspending the dealings within the fund will allow fund managers to sell the properties in an orderly manner – and not become a distressed seller.

This is one of the methods that fund managers are expected to use when there is a shock to the stock market and when there is an unexpected level of outflows. Fund managers can also change dealing charges or impose exit fees in an attempt to maintain a healthy inflow/outflow e.g. Aberdeen recently imposed a 17% exit fee on its property fund (which was reduced to 7% as redemptions eased).

When fund managers need to sell the properties within the fund to raise cash, it is reasonable to assume they would sell their “prime” assets as it would be easier to sell. Prime assets can be properties located within a prime area, have a long tenancy agreement, high quality of tenants e.g. Aberdeen Asset Management (“Aberdeen”) has marketed an office block at Hammersmith for sale.

The largest property funds in the UK are beginning to sell off some their assets which can make the pricing competitive for these buildings. There are worries that commercial buildings may be hard to sell (due to uncertainty of the future of Britain) but it may attract overseas buyers as the Pound has weakened across all major currencies.

Madison International Realty – a US firm has said they are planning to spend around £1bn in UK commercial properties over the next 6 to 18 months as they see an opportunity in discounted properties.

The Yield in Property Funds

Although Brexit has no doubt affected investors’ confidence in commercial property, it is still providing a reasonable yield for an income seeker. In some property funds, the yield will be further enhanced by the fund manager’s decision to devalue the properties within the fund e.g. Kames Capital implemented a 10% fair value pricing adjustment to the direct property values held within the fund.

Below shows the yield of some property funds that invest within the UK and overseas – the full list of funds can be found on Fund Space by filtering the sector to ‘property’:

Property funds investing within UK:

 

Fund name Historic Yield (%)
1Aviva Inv Property Trust 2 Inc* 2.20
3F&C UK Property 2 Inc 3.50
2Henderson UK Property PAIF Feeder Inc* 3.20
1L&G UK Property Feeder I Inc 2.90
1M&G Feeder of Property Portfolio I Inc* 3.41
1SLI UK Real Estate Income Feeder Fund* 3.20
Source: Providers’ factsheet

*Dealing currently suspended

Exposures outside of UK:

 

Fund name Historic Yield (%)
2First State Asian Property Securities B Inc 2.60
2First State Global Property Securities B Inc 2.40
3JPM Global Property Securities C Inc 1.67
3Premier Pan European Property Share Fund 3.20
3SLI Global Real Estate Inst Inc 2.33
  Source: Providers’ factsheet

1 – as at May 2016   2 – as at June 2016   3 – as at July 2016

Are Property Funds Still Worth Considering?

Despite the outflows, they still generate a reasonable yield and with the Bank of England cutting interest rate cut from 0.5% to 0.25% it’s debatable whether it’s worth putting any money in fixed term deposit accounts.

The stream of income should be steady in the coming years as property funds tend to have a long lease length e.g. as at May 2016, Standard Life UK Real Estate Fund has an average tenant lease of 9.1 years. This will help the fund absorb some of the volatility Brexit has brought to the market.

Even when the funds have suspended dealing, investors are still entitled to the payment of income so if you are looking for a long term stream of income, these suspensions are not necessarily a reflection of a struggling fund as it will protect properties from selling at a sub optimal price.

There is an argument that the wave of redemptions seen across this sector will act as a trigger in a freefall of property prices (as happened in 2008). However, according to the Financial Times, Aberdeen has successfully sold one of their properties for £124m from a purchase price of £76m. Although Brexit may have temporarily reduced the prices in these properties, it is important to note that it has not fallen to new low levels. In fact, it is arguably an opportunity to buy property funds at a discount with some funds either devaluing their portfolio or waiving dealing charges. L&G have recently reduced its devaluation from 15% to 10% which suggest there is a more positive outlook in the commercial property sector.

The Bank of England has said that measures such as Quantitative Easing will be used to stimulate the economy which should benefit UK businesses. Siemens and HSBC are examples of companies that have committed to UK regardless of the EU referendum results –property funds that have these tenants will benefit from the continued leasing of their properties.

Conclusions

Undoubtedly, the headline news that property funds have attracted caused panic across investors. In these times, it is best to remember why you invested in property funds in the first place and ask yourself whether your investment choices are still in line with your objectives.

The property sector is classified as a specialist sector – the funds are designed to mainly offer income and should be used as part of a diversified portfolio. As always, diversifying asset classes help spread the risk and so it is always important to review your portfolio regularly.

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.





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