The lights go on again in commercial property

The market is picking up after the economic darkness of the past two years, but there are still risks

A year of positive returns has helped to encourage some nerveless investors to return to the UK commercial property market.

A 16.9 per cent rise in the UK quarterly property index produced by Independent Property Databank since last September is just the headline figure behind which we've seen 12 months of rental growth and rising yields from office, retail and commercial property.

Return-hungry investors have spotted the growth and moved back into commercial property funds, after a mass exit in 2008 and 2009. The most recent figures from the Investment Management Association show that the commercial property sector was the third most popular with investors in June, jumping from seventh the previous month. However, while commercial property funds have delivered an average return of 10.83 per cent over the past 12 months, wind the clock back further and you see that over three years more than 26 per cent has been wiped off the value of these funds.

That raises fears that investors flocking to such funds now could be in for another nasty shock. Financial advisers are one group turning against the sector. According to a study from Reita, an organisation that actually promotes property investment, advisers now fear a fall in commercial property prices. Almost a quarter – 24 per cent – of advisers believe that prices will fall, compared with 6 per cent in January.

Is their concern well placed? "They reflect justifiable uncertainty about the economy over the next year or two, mainly in the light of public sector cuts," says Reita chairman Patrick Sumner. "Recent news of falling house prices exacerbates these concerns, but there are big regional and sectoral differences. We are in the early stages of a slow economic and commercial property market recovery, in the course of which there will be the odd lurch. But shares, in my view, are trading at the cheaper end of fair value, and dividends are sustainable."

Barry MacLennan, the investment director of property products at Standard Life Investments, runs a number of commercial property funds. He agrees that there are differences. "The recovery so far has been uneven. Central London office markets have pulled away like a train and are very strong, but elsewhere things don't look that great," he says. "Retail property hasn't been the easiest environment in the past two years and there's been a huge divergence of experience."

He concentrates on good-quality investment opportunities, rather than speculating on opportunistic, potentially high-growth investments. For instance, a new shopping centre due to open in the Olympic 2012 site in Stratford, east London, next year already has 65 per cent of its space pre-let, meaning it's likely to prove to be a reliable investment. Other shopping centres coming in the next couple of years could remain largely empty.

In other words, it's essential to do your homework before investing. Mr MacLennan thinks it can be a wise move, especially for those approaching retirement, but even then he cautions that commercial property should not represent more than about 15-20 per cent of an investor's portfolio.

The rise and falls in recent years shouldn't make that much difference to your approach to the sector. In the past decade the sector boomed as property development grew. It prompted an investor move into commercial property in the mid-1990s which almost reached gold rush proportions before the bubble burst in 2007. But the recent recovery and popularity of the sector could lead to a second wave of over-investment by ordinary investors.

That's the danger, says independent financial adviser Philippa Gee, the managing director of Philippa Gee Wealth Management. "The problem with commercial property is that it is treated like a fad investment, so people either believe it should be avoided at all costs or they should pile the majority of their money in," she says. "Indeed, I have come across financial advisers who share that belief and have suggested their clients invest 100 per cent of their portfolio accordingly, which is shameful, to say the least."

She suggests investors should consider having 5 per cent of their portfolio invested in commercial property. Danny Cox of adviser Hargreaves Lansdown agrees. "Property funds can be used an alternative to fixed interest in a portfolio as an income bearing asset," he says. However, he warns that they can be a little more expensive than fixed interest funds. "That's because the transaction costs of a property are high," Mr Cox explains.

In the past there have been liquidity issues, leaving investors sometimes unable to get at their cash. "Property fund managers reserve the right to delay encashments if they wish," says Mr Cox. "This is to prevent a manager being forced to sell a property at the wrong price during a downturn. These liquidity issues have been prominent in the sector since market falls in early 2007, though most funds are now running normally."

"I would suggest no more than 10 per cent of a portfolio, with the more adventurous having less exposure," says Adrian Lowcock, a senior investment adviser at Bestinvest. He favours accessing the sector through managed funds. "You do not pay a premium on the assets and do not need the large sums of money required to invest directly in property," he points out. "The fund managers look after all the paperwork, legal side and collect the rents."

Martin Bamford, managing director of advisers Informed Choice, remains a fan of the sector. "I accept that the prospect for stellar returns over the next 12 months does not seem likely. However, while valuations are not as attractive as they were last summer, the downside risk is limited by virtue of the losses already experienced," he says. He advises investors to limit exposure to 20 per cent of a portfolio and invest only for the long term.

Funds recommended are Henderson UK Property and SWIP Property Trust by Mr Lowcock. "Both have over 10 per cent currently held in cash, which means that liquidity shouldn't be too much of an issue," he says. Mr Cox picks Threadneedles Property Fund. "It's run by Don Jordison, one of the best managers in this sector," he says. "At times he shifts large parts of his portfolio to cash to protect investors from the downsides."

Expert View

Philippa Gee, Wealth Management

"Commercial property should be a part of an overall portfolio for investors who are willing to take a degree of risk. So perhaps it is not for the most cautious investors, but it is worth being considered by those with higher risk tolerances. It can help to give a well-balanced portfolio, to help investors work through different investment climates and should work best when set up alongside cash, bonds, equities and commodities."