Investing in Commercial Property: What You Need to Know

Commercial property fans cite the asset’s high and stable income as a reason to invest but there is an issue with liquidity

Emma Wall 12 December, 2016 | 12:59AM
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This article is part of Morningstar's Guide to Alternative Investing; providing everything you need to know about property, commodities, infrastructure and other diversifying assets. 

In 2014 and 2015, the commercial property index delivered double-digit returns – particularly impressive if you consider that the FTSE 100 was flat or falling over this period. As a result commercial property funds attracted significant inflows, offering yield where all other asset classes’ income was dwindling, and total returns for those wo preferred to accumulate pay-outs.

But in May this year, Morningstar Investment Management’s Simon Molica was starting to get nervous, saying: “There has been a strong recovery, but you've got to question what the risks will be and we think of liquidity as being very important. We are actually quite cautious of commercial property and are looking to exit as soon as possible in all but our income portfolios.”

Molica was proved right when a number of open-ended UK commercial property funds suspended trading during the first week of July, thereby freezing investors’ rights to redeem their shares.

Investors were hit with share price markdowns as funds including Henderson UK PropertyM&G UK Property PortfolioStandard Life UK Real Estate and Aviva Investors Property Trust, swung their prices down from offer to bid or mid pricing, thereby lowering the prices of the funds by around 5%-6.25%.

In addition to imposing those high exit charges, a number of funds under went fair value adjustments, bringing their values down by an additional 4%-5%. The moves were in response to redemptions which were triggered after Britain voted to leave the European Union and the market speculated on the impact on the property sector.

Commercial Property and Liquidity

Property fans cite the asset’s high and stable income as a reason to invest but there is an issue with liquidity. In 2008, commercial property investors were unable to access their cash as several funds imposed exit restrictions. These open-ended funds – including offerings from Aviva and the now-defunct New Star - faced a deluge of sell requests as the property market crashed and investors wanted out.

However due to the structure of the funds the management was unable to fulfil their wishes as they couldn’t offload the property fast enough. Property is illiquid, unlike stocks which can be bought and sold electronically in a matter of seconds property is slow to trade and has high transaction costs.

But the nature of an open-ended property fund is such that when there are mass inflows it is most likely to be at a time when investable assets are difficult to source, and mass outflows come at a time when all the manager wants to do is preserve cash.

Of course a portfolio made up solely of equities is not well diversified, but many investors often fail to consider their existing property exposure before buying funds.

How to Mitigate Risks

Managers also carry cash buffers to provide some balance in the portfolios in terms of liquidity, but this then means there is a restricted amount of redemptions that can be met through this buffer, explains Morningstar analyst Muna Abu-Habsa.

The mismatch between the open-ended structure of daily-dealing direct property funds and the illiquid nature of their underlying investments is bad for investors she says. Time and again investors are faced with making the difficult choice between withstanding the woes that strike when fear overshadows the property market, and paying a high price tag to liquidate their investments.

This does not mean that property cannot play an important part in your portfolio – the yields offered by property funds today still outstrip many equity funds by some margin. But investors must be aware of the liquidity risks and invest for the long term as part of a diversified portfolio. It may be useful to think of property as a bond-like investment, although without the guaranteed coupon – invest for the income and leave the capital alone.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Emma Wall  is former Senior International Editor for Morningstar

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