Investors blind to property fund perils

Experts warned investors this week not to get carried away with the recent impressive returns and market rally in property. Funds investing in property company securities have risen by up to 72.3 per cent over the past 12 months, triggering a flurry of extra cash into the IMA UK Property fund sector. In the last year, 12 out of the 21 funds within the sub-sector have gained more than 50 per cent.

Data from the Investment Management Association showed that investors piled into property funds in the first quarter of the year, making them the fifth most popular sector in February.

However, sector experts are warning of a hidden and looming danger.

Those investing over the past 12 months will notice that funds investing in property company securities (as opposed to bricks and mortar) made gains across the board.

The impact of the economic downturn hit the sector hard, but since the recovery began there has been marked variation between the best and the worst funds.

The best performer of the funds investing in equities has been the Fidelity Global Property fund, which returned a stunning £723 on top of an initial £1,000 investment, up until the end of March.

Almost as impressive is First State's Global Property Securities fund, which managed to return a healthy £693 on top of the same £1,000 investment.

However there are a whole host of factors which could strip property funds of their recent healthy gains.

Shai Patel, director of the independent financial advisers Generation Financial Services, advises not to invest, despite the massive amount of money going into property at the moment.

"If you are in an economy which is recovering, the last thing you should ever buy is property," he says. "It lags the economy by between six to 12 months, and we are still not out of the woods yet. The economy is extremely volatile right now."

Mr Patel said that a number of factors still need to be known before he would recommend that his clients return to the sector.

"To be in a position where they think they could buy in again, investors need to have a stable environment, and that will be down to the banks. The banks are still not lending. Considering that the majority of property funds are leveraged, to have a stable environment, you need banks lending in that sector."

Another consideration for investors is the impact that a mass retreat from the sector could have on funds.

Many of the sector's recent inflows have come from overseas, with foreign short-term investors looking to take advantage of sterling's weakness, according to Mr Patel.

"Normally, stabilisation occurs and it is down to demand. But this is not down to demand, it is because of weak sterling, international investors are buying in," he says. "These guys are not looking at long-term investment prospects. They are looking to make a quick profit. As soon as they have done that, you will be back to square one."

Added to fears over these specific issues are concerns that many investors are oblivious to the level of gearing within the funds in which they invest.

In simple terms, gearing is the level of borrowing that a fund has taken on in order to magnify gains, but it can also magnify losses if the market moves against the fund.

There is no greater example than a property investment trust ran by Invesco, which tanked during the economic downturn. Without doubt, it was the biggest disaster story of property funds over the past three years. A £1,000 investment in the Invesco Property Income Trust would have lost practically all of its initial investment, leaving the investor just £45 after three years in the fund – a truly astonishing loss of £955.

The £6.9m investment trust was still in breach of its banking covenants at the end of December, although it has since managed to sell some of its assets. Its performance over one year was also much healthier, albeit diminishing once again over the most recent six months.

The fund's manager – Rory Morrison – has been reluctant to speak about the fund's disastrous performance, and analysts at Numis have even stopped reporting on the investment trust because of its dismal performance. Invesco declined the opportunity to comment on the fund.

While all investment trusts had a difficult period over three years, none suffered to the extent of the Invesco trust, highlighting the potential pitfalls of not researching a property fund adequately.

The above research is taken from What Investment magazine's property fund survey appearing in the May issue.