How To Pick A Product: Commercial Property

For most homeowners, their house is the largest asset they own, meaning huge swathes of the population have significant exposure to bricks and mortar.

Commercial property, however, should be considered as a separate asset class. Chase de Vere, the independent financial adviser, typically invests between 5 percent and 15 percent of clients' portfolios in commercial property.

Patrick Connolly, its head of communications, said: "Commercial property can provide consistent long-term returns and this, coupled with its diversifying nature which offers some protection from stock market falls, means that most investors should look at holding commercial property investment funds in their portfolio."

But which vehicle is best: an active mutual fund, an investment trust, a tracker or an exchange traded fund (ETF)?

Active Funds

It is important to understand where a property fund invests. Some invest mainly in the shares of property-related companies, such as house-builders, while others invest in actual properties.

Chase de Vere only recommends commercial property funds that invest in bricks-and-mortar property as these have far less correlation to the stock market and are less volatile than property shares.

Property funds it recommends include Henderson UK Property, L&G UK Property and M&G Property Portfolio. Advisory firms Strategic Solutions and MPA Financial Management also like Henderson UK Property.

Phil McGovern, managing director of MPA, said: "We like investing in property funds for a number of reasons – income yield, low volatility, un-correlation to stock markets and bond markets. We've used [active] commercial property funds – we prefer Henderson UK Property, but also use M&G Property Portfolio and Threadneedle UK Property Trust – as a replacement for bond funds as they have a similar yield and lower volatility."

Henderson UK Property invests in retail, leisure, office, industrial and private healthcare facilities, as well as care homes and hotels, with a focus on the south east, and has a 3 percent yield.

Martin Waistell, a senior member of Strategic Solutions' investment committee, said: "Property is a fantastic diversifier, provided you pick the right vehicle for the asset class. The fund we use has had a low correlation to every other in our portfolio. We've picked up a decent natural yield along the way and have benefitted from the fund's lower volatility [compared to rival funds]."

The fund's managers, Marcus Langlands Pearse and Ainslie McLennan, adopt a 'responsible property investment agenda', which means they work with tenants to find ways to optimise running costs. "We were impressed that they kept the fund open throughout the credit crunch years and believe they'd be positioned to do so again if the situation arose," added Waistell.

Investment Trusts

Hargreaves Lansdown has historically recommended the Threadneedle UK Property Trust, but has no bricks-and-mortar commercial property funds on its 'buy' list just now.

"The reason is liquidity – property is timely and costly to buy and sell," said Adam Laird, its head of passive investments. "Most funds keep 10 percent or more in cash to satisfy redemptions, which is a drag in rising markets."

Connolly warned of potential liquidity challenges on the horizon. "[Property] fund managers have seen large inflows meaning that some funds are now sitting on quite high levels of cash. With lots of money chasing property investments it becomes even more difficult for managers to find real value and we've seen in the past the potential liquidity problems which can arise if too much investment money floods into commercial property."

Investment trusts are closed-ended in nature, making them ideal for investing in less liquid asset classes, such as property.

Chelsea Financial Services, the discount broker, likes TR Property investment trust, which invests in both direct property and property-related shares. It has been a "consistently strong performer", according to managing director Darius McDermott, and yields 2.7 percent. It can be bought at a 5.3 percent discount to net assets.

Real estate investment trusts (REITs) also provide a liquid means to access commercial property. These trusts are required to distribute 90 percent of tax-exempt profits as property income.

However, Connolly said: "We don't use REITs. They can invest in actual properties or the shares of property related companies, but as they're listed companies traded on the stock market they behave like equities and so will go up and with stock markets. This doesn't provide the diversifications benefits which can be achieved with bricks-and-mortar commercial property funds."

Hargreaves Lansdown has seen demand in the past for niche plays, such as Tritax Big Box REIT, which concentrates its investment on warehouses and distribution centres.

Index Tracker Funds

For most investors, a diversified portfolio of REITs could be better option to spread investment risk, according to Laird.

He is aware of only one tracker fund in this space – the BlackRock Global Property Securities Equity Tracker. It tracks the FTSE EPRA/NAREIT Global Real Estate Series Developed index, which covers around 325 listed global property companies.

Bristol-based Paradigm Norton Financial Planning likes this approach as a means of keeping costs low while aiding portfolio diversification.

Chartered financial planner Steve Williams said: "Using an index tracking REIT allows us to keep costs as low as possible, thereby enabling more of the returns to be paid to the investor.

"Using a global fund enables us to maximise diversification and using a REIT structure increases the liquidity for investors when compared to direct property investment.

"Although REITs are essentially shares in property companies as opposed to direct investments into bricks and mortar, the fact that REIT returns are driven by the underlying property assets over the medium to long term should provide a diversification benefit when introduced into a basket of equities."

ETFs

There are a number of ETFs affording access to this asset class, too. One low-cost, diversified option is HSBC FTSE EPRA/NAREIT Developed ETF with ongoing charges of 0.4 percent, while iShares Developed Markets Property Yield ETF is more expensive, with ongoing charges of 0.59 percent, but also a focuses on higher-yielding property companies.

It is one of the most popular ETFs. "Property is a popular asset class," said Laird. "I was surprised earlier this week when I checked the London Stock Exchange ETF list and iShares' global property ETF was ranked number seven this year for inflows in the equity ETF area."

However, he sounded a note of caution: "Look out for interest rates. Many property companies are very reliant on debt. That will become costly when interest rates begin to rise."