All days at the office are good for investors in steel and glass

Funds that put our money into business premises have been going up and up. But has the market now reached its peak?

Looming large in Liverpool Street railway station recently has been a poster offering a seductive view of London. Above a night portrait of the City and its iconic skyscrapers - including the Swiss Re tower, more commonly known as the Gherkin, Tower 42 and Canary Wharf - twinkles a panoply of glittering stars.

The glossy ad is not there to highlight the romance of the capital for the benefit of tourists, though. Rather, it's an attempt to convince a domestic audience to invest in the New Star commercial property fund.

Along with other investment companies - including Norwich Union, M&G and Scottish Widows - New Star has been riding a huge wave of interest in these funds, with £2.2bn poured into them since the start of this year, according to the Investment Management Association (IMA).

For individual investors, the returns come from two streams: rental income and increases in the capital value of the buildings themselves. When they put money into a fund, they buy units at a certain price; if the market does well and rents and capital prices stay strong, the price of their units will rise.

And rising is what they've been doing, with strong demand from business for premises across the UK and robust rental levels.

Adding to the excitement has been a flurry of activity over the past couple of weeks: the Gherkin is up for sale with a price tag in the region of £600m, while property tycoon Simon Halabi is selling his £1.8bn portfolio of properties including the Aviva building in the Square Mile.

That said, London landmarks tend to occupy only a fraction of the funds' portfolios, with much of the cash being spent on the more mundane - on factories, retail parks, DIY shops and urban warehouses throughout the country.

One of the incentives for investors in commercial property has been a change in the rules enabling them to buy into these funds using all or part of their tax-free £7,000 allowance for individual savings accounts (ISAs). Another draw has been the continued big gains: like UK house prices, commercial property has surged in recent years and shows no sign of abating.

Over the past five years, the IPD UK All Property index has returned 99 per cent, compared to 60.5 per cent from the FTSE All-Share company index.

Change the period to 10 years and the figures are even more impressive. While the FTSE All-Share has returned 110.8 per cent, that's less than half the 254 per cent notched up by commercial property.

However, some are now wondering whether this hot streak has much further to run. For example, Mr Halabi's property portfolio is thought to be the largest ever to be put up for sale in the UK, and a handful of industry parties have interpreted this as a sign that the market doesn't have much further to rise.

And while the Royal Institute of Chartered Surveyors (Rics) predicts that commercial property returns will hover around 17 per cent this year, it believes they will fall to 9 per cent in 2007.

John Cartwright, the manager of the M&G property fund, says the average yield from rent in the 12 months to August 2006 was 5.6 per cent, down from an average annual yield of 7.3 per cent over the past decade. "In some parts of the country, yields are at their lowest level in 20 years."

Although rents are rising, says Justin Modray of independent financial adviser (IFA) Bestinvest, "they have failed to keep pace with rising property prices - and so yields have dropped."

Tim Cockerill of IFA Rowan is also concerned that, amid the seemingly insatiable appetite for this asset class, some money is more or less sitting idle. "Many of these funds have high levels of cash because they cannot invest it quickly," he says. "That's due to lack of available properties and the slow process of finding good opportunities."

And if a big chunk of money is in cash earning interest at standard bank rates, rather than being invested, it's probably not getting the best possible return.

"Norwich Union Property fund, which is £3bn in size, is currently sitting on nearly £600m. That's 20 per cent cash," says Mr Cockerill.

Mr Cartwright agrees that the availability of attractive property remains limited and well below demand. In the short run, he expects the strong returns to continue; over the longer term, he expects a gentle slowdown.

"History indicates that a gradual adjustment of pricing to a more sustainable level is likely to be how the current boom will end. It doesn't quite imply a spring of hope but nor is it a winter of despair."

Anna Bowes of IFA AWD Chase de Vere says commercial property still has a place in a balanced investment portfolio. "As it is not correlated to shares or bonds, it offers you some diversity and stability."

Depending on your attitude to risk, and on what funds you already hold, commercial property could make up between 5 and 15 per cent of your portfolio, she adds.

AWD Chase de Vere likes M&G Property while Rowan favours Resolution UK Property. Bestinvest recommends New Star Property, Norwich Property and M&G Property.

Independent Partners; Do you need financial advice on your investments, pension or insurance? Book a free consultation with an independent Financial Adviser at VouchedFor.co.uk

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