Investing in property can offer a good alternative to stocks and bonds and be used to diversify a portfolio.
While most people will be more familiar with buying residential property to rent out as a landlord, it is also possible to invest in commercial property.
From office buildings to retail locations and industrial sites, there is a wide range of building types to target, and the way most investors do this is by buying units in a property fund or shares in an investment trust.
In this article, we cover:
- What are property funds and how do they work?
- How do open-ended funds work?
- What are the benefits of investing in property funds?
- How can you invest in property funds?
- Are property funds a good investment? The expert view
What are bonds and how do they work?
What are property funds and how do they work?
Property funds essentially involve an asset management firm pooling money from clients and investing in property on their behalf, for a fee. The main types of buildings that typically sit in property funds include offices, retail locations and industrial buildings.
The funds seek to generate an income by renting the buildings out, and to grow their capital through the value of the properties going up in the future.
Some property funds will also invest in residential property such as blocks of flats, but this is generally a small part of the portfolio.
What is happening to property funds?
Property funds have hit the headlines recently for the wrong reasons.
Investment firm M&G announced this month that it is closing down its flagship property fund, the M&G Property Portfolio, following a wave of withdrawals. The fund was worth £2.5bn pounds in 2019 but has declined sharply since the pandemic to just £565m as the closure was announced on October 19.
This move followed in the footsteps of other large UK property funds run by asset managers including Aegon and Aviva.
Property funds have been on thin ice for several years due to concerns over liquidity, even before the pandemic.
Due to their nature, there is a fundamental mismatch between the need to let investors take money out quickly and the time it takes to actually cash in on a property holding.
If a property fund does not have enough cash on hand to meet the withdrawal requests it must sell some of the buildings it owns. And selling a building, as any homeowner knows, can be a long and complicated process.
To compound the difficulty, if potential buyers know a fund needs to sell an asset they may try to take advantage of this and offer a lower price.
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How do open-ended funds work?
Open-ended investment companies (OEICs) are investment funds that issue units to investors corresponding to the amount of money they put in. The more money that flows in, the more units they issue, hence the term open-ended.
When an investor wishes to withdraw money, they give up the units and receive the cash equivalent. The firm managing the fund will keep some cash on hand to return to investors upon request.
This is not always enough to cover the amount of withdrawals requested, particularly when markets are volatile. In this situation, the manager has to sell some of the investments in the fund to raise more cash.
The recently closed property funds such as the M&G offering were OEICs.
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What are the benefits of investing in property funds?
There are two broad benefits to investing in a property fund. Firstly, there are the returns from the investment itself.
A property fund can offer an income flow that is derived from the rental yield on the buildings it owns. Over time it can also create a rise in the value of the initial investment, as long as the properties the managers buy increase in value.
The second key potential benefit is diversification. A property fund may have different characteristics to a fund investing in the stock market, and move in value differently. This can help make an investment portfolio safer and more resilient to fluctuations in the markets.
This is not always the case, and property market movements can match the stock market at times, as it did during the global financial crisis.
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Are property funds risky?
As with all investments, property funds do carry risk. The risk is a necessary part of the deal when seeking to make a profit. The value of the buildings and the amount of rental income they can generate can go down as well us up.
There are certain aspects of property funds that create a different type of risk to funds buying only shares. The principle one is liquidity.
Having sufficient liquidity refers to being able to sell an investment quickly and easily at a price determined by an efficient marketplace.
Property funds can be very sensitive to the health of the economy in the country and even the region that the properties are based in. Rental demand can fluctuate significantly when the economy improves or deteriorates. This not only affects the rental yield of a property, but also its market value.
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How can you invest in property funds?
Property funds can be bought on the same online investment platforms as equities funds and stocks.
There is an important distinction to be made. OEICs, as described earlier, will issue you with units in exchange for your investment. When you want your money back you must request it. Usually this would happen within a day, but there can be delays.
In extreme cases of market volatility triggering a large number of redemptions, a property fund may even be “gated”. This means redemptions are halted until the fund is able to sell assets to raise more cash and market conditions improve.
When will interest rates go down?
What are REITs?
Closed-end property funds are known as real estate investment trusts (REITs). These are listed companies whose sole focus is investing in property.
They have shares listed on a stock exchange so an investor can simply buy and sell shares in a REIT in the same way as any other public company.
“When the economic outlook isn’t so good, or when performance has been poor, investors tend to sell property funds,” said Emma Wall, head of investment analysis and research at Hargreaves Lansdown.
“This often forces the manager to sell properties to give investors their money back. Commercial property isn’t easily bought and sold. It’s time-consuming, labour-intensive, and expensive.
“When fund managers can’t sell assets fast enough to meet investor redemptions, they have to suspend dealing. Because of this mismatch in liquidity, we do not consider daily dealing open-ended funds as the most suitable vehicle for investing in bricks and mortar property.”
She added: “Physical property investments are best done in a structure which aligns with the fluctuating liquidity of the asset class – such as a closed end investment trust, where the discount or premium mechanism accommodates for the impact liquidity can have on the value of the assets.”
What is physical direct property?
This refers to buying buildings, the actual bricks and mortar, or glass and steel in many cases. This contrasts with buying loan books or bonds backed by buildings, which some investors choose to do.
“The recent noise has been centred on property funds that own physical direct property; office blocks, warehouses, hotels etc,” said Ben Yearsley, investment director at Shore Financial Planning.
“This type of direct property fund has been under the cosh since 2016 – nothing actually to do with Brexit in my view, just investor sentiment.
“These funds typically hold 70% in physical property and 30% in cash to manage liquidity. These funds allow investors to exit daily and should largely be avoided due to the mismatch between allowing investors daily exits and the many months it takes to sell a property.
“I believe physically invested property funds only allowing monthly or quarterly exits are fine,” he added.
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Are property funds a good investment? The expert view
“On the outlook for property generally, I’m optimistic,” said Yearsley. “Prices have fallen from unrealistically high levels, and from an income perspective especially it looks good. The work from home phase post Covid seems to be abating giving more certainty to the important office sector.”
Property shares have been hammered in the past 18 months as investors assess the impact of higher interest rates on property prices – most people borrow to buy property so a 7% rate compared to say 3% has a big impact on what they are prepared to pay.
“Companies with high levels of debt need to be avoided – they might not be under pressure today but once debt needs refinancing they could be in trouble,” Yearsley continued.
“With interest rates nearing or at peak in many areas, investors are finding it easier to assess worth and therefore falls in property share prices are looking overdone, leaving good value in the sector.”
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