In our opinion the commercial property market could well be poised for a period of growth.
“Giant pension fund piles into property as analysts say now is the time to snap up cheap exposure” is typical of recent headlines from the money and business pages of the national press. And they may have a point. Property investors have seen their holdings fall on average 11.4% over the past five years (source Lipper), with some investors losing a quarter of their cash. This in turn is leading many to believe that the asset class is now undervalued and primed for recovery.
Why might your customers be interested?
For most people, the largest investment they make in the property market is in their own home. A fortunate few, branch out into ownership of rental properties, which has in many cases provided a healthy income stream and some potential for capital appreciation, but also brings with it landlord responsibilities and the anxiety of finding good quality tenants. However, for those wishing to invest in property without the complications of buying and managing a rental property themselves, or wanting to diversify into non-residential buildings, property funds provide an alternative as they allow small investors to become part owners of many large properties.
With direct ‘bricks and mortar’ property funds, rental income can be relatively secure in comparison to other asset classes because of factors like long lease lengths (typically five years or more), less risk of default than residential properties and upward-only rent reviews, meaning that rental income often increases by at least inflation each year. However a major downside of direct commercial property investment, is that property markets are highly illiquid compared to most other financial instruments such as equities or bonds, meaning that buying or selling a property can take a long time, and stressed conditions can make it difficult to sell a holding in the fund. In addition the higher than average costs associated with buying property such as stamp duty, surveys and legal fees need to be paid and can affect the value of the fund, rental growth is not guaranteed and unpaid rent could affect the performance of the investment.
Alternatively indirect commercial property funds can buy shares in companies that invest in property and tend to be more liquid investments. The majority (over 80%) of these property companies are Real Estate Investment Trusts (REITs), and have greater tax benefits than other listed property companies. REIT companies don’t pay corporation tax on their assets, on the condition that 90% of profits are paid to shareholders as dividends. REIT holders pay either 20% or 40% tax, on dividends because they’re classed as property-letting income.In contrast Property Investment Trusts, which pool money to buy property and property company shares are considered to be like any other company, so tax on dividends is only 10% for basic-rate payers and 32.5% for higher-rate payers.
Why now may be the time to invest?
Analysis of returns from 42 funds in the IMA Property Sector by shared equity mortgage provider Castle Trust showed the worst fund lost 26.6% over the period from mid-2007 to June 2009 and the Investment Property Databank Index lost 42% of its value. Since then there has been a gradual recovery but this has been below trend when compared to other asset classes.
Many analysts are commenting that these indicators show contrarian investors are poised to snap up property funds. Caisse, Canada’s largest pensions company, announced in January 2013 plans to buy C$10bn of global property over the next 18 months to boost returns.
UK commercial property prices fell in 2012. But Legal & General’s own property team believe that there are a number of drivers, particularly the attractive valuations available in the sector, that makes them more optimistic about returns in 2013 and beyond. They’ve taken the view that assets such as equities have already seen the benefits of loose monetary policy, and commercial property could be next, although conditions may remain challenging for certain sectors and asset types.
Standard Life recently commented that property could be the surprise profitable asset class of the next decade, predicting better returns from bricks and mortar than shares. Rental yields currently sit at 6%, compared to the average FTSE 100 company which pays a dividend of 3.5% or 2% from a UK Government bond.
Cass Business School said Caisse’s plans to up property exposure were typical of pension funds looking for income in non-core assets such as property. With its predictable long-term, and usually inflation-linked, income streams, and attractive premiums to compensate the investor for their illiquid nature, property assets currently offer more attractive yields than bonds of a similar risk profile. Indeed, in the final quarter of 2012, property proved to be three times more popular than infrastructure debt as the pension scheme de-risking asset of choice. With gilts unlikely to rise by any meaningful extent anytime soon, there is good reason to believe that non-core property investment will continue to strike a chord with those UK pension schemes who want to de-risk and more efficiently match their assets to their liabilities.
So – is it time to take a look at your clients property investments again?
Of course, as always, all the usual warnings and caveats apply, but we strongly believe that property is worthy of further consideration, and could retake its place in portfolios as a diversified income generating mainstay for some of your clients.
External Funds Director,
Legal & General
Investment Management Research Unit (IMRU).
For further information please contact your Legal & General representative. Alternatively call 0370 050 0614*
Lines are open from 9am to 5pm Monday to Friday.
*We may record and monitor calls. Call charges will vary.