Signs of life in crippled property fund market

Some funds believe the worst is over, with yields proving attractive.

Property funds – which invest in offices, shops and other commercial buildings – have slumped 40 per cent since hitting their peak in June 2007. Does that mean it's time for investors to pile in to take advantage of some juicy recovery?

The specialist property fund developer Eaton Investment Management believes so. It has teamed up with the financial services company LLP Services to launch a commercial property fund, which will look to capitalise on the current "exceptional market conditions".

The Eaton Active Special Opportunity Property fund aims to raise £8m from investors and borrow £12m to create a £20m property portfolio. It will target low-density, income-producing properties that can benefit from planning gains. In other words it will seek out properties that already have planning permission in the belief that the consent will add significant value while not exposing the fund to any development risk.

Launching a property fund in the face of the current real estate slump may appear counter-intuitive, but Eaton is looking to exploit a specialist niche. Minimum investment in its fund is £50,000 which means it's not for the tentative investor.

In fact, anyone speculating that the property market has reached the bottom is likely to be proved wrong, if the experts are to be believed. Any recovery is likely to be months away at best, says Malcolm Naish, head of property at Scottish Widows Investment Partnership. In fact, he predicts that the commercial property market has a further 10 per cent to fall.

"It will touch bottom during 2009 but I am expecting values to drop off by another 10 per cent over the next three to six months," says Mr Nash. "We're expecting a slow recovery in the next 12 months after that." He says that rental income will be under some stress because of the broader economic situation and there is increased risk of some tenant failures as job losses begin to bite.

Double dip

M&G Property's fund manager Fiona Rowley says the UK commercial market is in the middle of a double dip, as valuations move from a period of correction to one of adjustment to a cyclical downturn.

"I expect the rate of decline to continue slowing over the next few months, although the very near term will undoubtedly remain challenging," she says. "Falling capital values are being driven more by weakening rental prospects due to lower tenant demand, as a consequence of the economic cycle, than by shifts in yield expectations."

Their view is backed up by a report from ODL Securities which showed that investors in property funds should be cautious. It found that, while commercial property stocks had done well in recent weeks, commercial property in general was due to fall by as much as 25 per cent in 2009.

Meanwhile IPD – which publishes monthly property performance figures – warned that UK commercial property values will fall further. IPD said rental levels continued to slide in February, falling 0.93 per cent – the sharpest single month movement so far in this current recession. The fall was driven by weaker office rental, which fell by 1.74 per cent over the month, the firm said.

"The re-pricing cycle continued to run its course, now close to a 40 per cent overall write-down since the peak in June 2007," says Ian Cullen, co-founding director at IPD. "Perhaps the most notable feature of the results, however, was the further weakening in office rental values, recording over three times the drop of the other major sectors."

Bottoming out

There were encouraging signs at the beginning of the year, according to M&G's Rowley, who says that three successive record monthly falls in capital values suggested an element of bottoming out. "But I expect the rate of decline to continue slowing over the next few months. Falling capital values are being driven more by weakening rental prospects due to lower tenant demand, as a consequence of the economic cycle, than by shifts in yield expectations."

However, lower returns from savings accounts is making yields of 7-8 per cent on commercial property look more attractive to investors, points out Naish.

"The sector is being helped by the low rate of return of savings accounts but there's also a boost from strong interest in UK commercial real estate from non-UK investors."

Naish says the UK is further ahead in the cycle than continental European markets, but it is also a fairly attractive real estate prospect as it is pretty transparent and has good levels of liquidity. "But a key component is the depreciation of sterling against the euro, which leaves European investors getting more for their euro in the UK."

With falling property values, many investors have chosen to withdraw from the sector. It's hard to blame them as they experienced sharp falls in the value of their investments during 2008.

But the flight has forced some funds to sell good value properties to raise the money to pay fleeing investors. This in turn has presented opportunities for other investors, such as the veteran fund manager Bill Mott who now runs the Psigma Income fund. He has recently bought into three property companies – Hammerson, British Land and Land Securities – on the belief that their rights issues will give them cash to buy property at the bottom of the market.

Redemption delay

Some investment managers have resorted to putting withdrawal restrictions on their commercial property funds, to stop a rush of frightened investors causing a dilution of assets. Funds managed by Friends Provident, Aegon and Scottish Widows were temporarily closed to withdrawals at the start of 2008 and this year investors in Standard Life and Norwich Union property funds have had to face withdrawal restrictions. It means they now face lengthy delays – of up to six months – in getting their money out of the funds. Such moves alone are enough to deter new investors to property funds.

But the action is to protect the funds and remaining investors, points out Naish. "Being forced to sell our best assets in a hurry means we won't get the best price for them. A redemption delay gives us more time to achieve better prices, which is good for all our investors."

He believes that there are positive signs for the commercial property market. "Once we see tenant demand pick up, we think we'll be in a position to see good returns in three to five years," says Naish.

M&G's Rowley agrees. "We expect the very near term to remain challenging but believe yields will peak later this year," she says. "Many properties are now attractively priced and the market as a whole is below what we would consider fair value. On that basis, the UK appears to be the best value core commercial property market in the world and its appeal to international investors should be further enhanced by the weakness of sterling."

She adds that previous drops of this magnitude in UK property – in the mid-1970s and early 1990s – were followed by strong and swift recoveries. Bricks and mortar has always been an important mainstay of a balanced portfolio and is likely to remain so. But investors expecting swift rewards will be disappointed.

Only hours left to use tax breaks

You still have time to beat the Revenue by sheltering money from tax charges. You have until midnight tomorrow to make use of the 2008-09 tax allowances, such as putting £7,200 into an investment ISA. However, it'll mean investing online or over the telephone to beat tomorrow's midnight deadline for most firms. Not all investment houses are staying open this weekend. If you fancied sticking your savings in a Gartmore or Aberdeen ISA, for instance, you've already missed the boat.

But others will allow investors to invest today or tomorrow. If you're planning to make a last-minute dash, check right away that your chosen firm will allow it. Barclays Stockbrokers, for instance, is accepting online applications up until 11.50pm tomorrow night but closes the door on telephone applications at 4pm tomorrow.

Fidelity, on the other hand, will allow keen investors to hand in application forms at their offices in Oakwood and Kingswood right up until the tax year deadline at midnight Sunday April 5.

Do people really leave it to the last minute? "Yes, yes they really do. Last year our last Sipp was set up at 11.56pm on 5 April," revealed Tom McPhail at Hargreaves Lansdown.

Choosing a property fund

"Before investing in a property fund, I'd wait for commercial property shares to show some signs of life," advises Brian Dennehy, managing director of the Kent-based independent financial advisers Dennehy Weller & Co. "I don't believe that will be in the next month or two, but probably later in the year."

He favours funds that are managed well. "M&G Property is one of the better-managed funds, along with New Star UK Property. They're both open and honest about investment opportunities. Neither is saying you should buy right now."

The troubled New Star fund management group was taken over by rival Henderson earlier this year. "We'll have to wait and see where New Star fits under the Henderson banner. Hopefully they'll leave it much as it was," says Dennehy.

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