Invest abroad for bigger property profits
Investors have made great profits from commercial property in the UK over the past five years. But I think to make good money you now need to look overseas.
It isn't just house prices that have boomed in the UK in the past five years. The price of offices, shops and warehouses has also soared, and people who invested in this sector have made far bigger profits than anyone expected. On average, funds investing in commercial property have turned £1,000 into £1,650 (five years to 1/9/2006, source Money Management). That is an annual return of over 10%, an amazingly high figure for what is supposed to be a pretty stable asset.
One of our Best Buy Property funds, New Star Property, has converted £1,000 into £1,529 in the past three years, an annual return of an even more impressive 14%.
The chart shows how the UK index of property shares has soared over the past five years while the wider UK stock market index has made little progress.
FTSE 100 Index
FTSE 350 Real Estate Index
Lack of supply PLUS low interest rates equals bonanza
There are two reasons why UK commercial property has been such a great bonanza. One was the dearth of new developments until after the millennium, which created shortages of many properties in the desirable South East. Even more important, though, was the steady fall in long-term interest rates.
The value of a commercial property is determined by projecting the annual rent into the future. You then 'discount' the value of all future rents over 20 or 25 years back into today's money. The 'discount rate' is the long-term interest rate, so the lower this is, the greater the present value of future rental income and therefore the more someone will pay to get their hands on it.
Over the past two years a slew of new property funds have been launched, and institutions like pension funds, which had cut their investment in property over the previous decade, have scrambled to invest tens of billions in this area. As a result, a lot of UK commercial property now looks pricey according to analysts.
Regional factors are becoming more important
Up north, you may still get a rental yield (the rent expressed as a percentage of capital value) of 5.5% on a new office block, but in the south-east offices yield as little as 4%. Indeed Swiss Re, the owners of the City's single biggest office building, the 'gherkin', are looking to sell it on a yield valuation of under 4%.
Little wonder, then, that most managers have grown considerably more cautious about the prospects for the market. Especially for retail, where the long-running consumer boom led to soaring rents that are clearly vulnerable to any slowdown in our collective desire for retail therapy.
So most property managers now expect annual returns of 7% or less for the next few years. Against inflation at 2-2.5% that is still pretty good, but investors used to much faster growth may not be that impressed.
Time to move abroad for property buys
But you do not have to confine your property investment to the UK. Several investment managers have recently launched funds that invest in commercial property around the world, and this makes a lot of sense.
The 'property cycle' of rising and falling valuations naturally follows the business cycle, which proceeds at a different pace in most countries. So managers can validly argue that if property looks overpriced in the UK, they can buy in the US, or in Hong Kong or Japan or Australia.
Clearly it would be unrealistic for an investment manager to have teams of surveyors and valuers all over the world, and most managers buy into property in other countries mainly through property companies that are listed on a stock exchange. In many countries these are called Real Estate Investment Trusts (REITs), which own and manage properties on behalf of their shareholders.
One of these internationally-investing funds is in our Best Buy list:
Standard Life fund is my top choice in this sector
Standard Life Investment's (SLI) Select Property fund is managed by Andrew Jackson. He's an impressively energetic and knowledgeable character and has the backing of a property team that looks after billions invested in property worldwide by Standard Life's insurance funds. The fund has 20% of its investments in the UK, 26% in the US, 16% in Europe and 38% elsewhere including Australia, Japan and Hong Kong.
Several other groups have launched similar funds. They include Skandia Global Property, Schroder Global Property, Fidelity Global Property and Franklin Global REIT. I prefer the SLI fund to these because most of the others have 40% or more of their cash invested in the US and however big the US market is I think the whole point of this type of fund is to get as wide an international spread as possible. And with £650 million invested, SLI can also buy directly into individual properties, which it has recently done in Japan amongst other places.
The other reason why I believe an element of direct investment is important is that shares in property companies are a lot more volatile than the values of the buildings they own, because investors tend to value their shares either too high or too low in relation to the value of their assets - that's just the way stock markets work. By contrast, an office building may be revalued every month or two, and its value will be far more stable. That means I expect the SLI fund to be less volatile than funds like Fidelity's and Franklin's that only invest in shares.
Property is non-correlated with shares
If you own or plan to own shares or share-investing funds, one of the main reasons for owning a property fund is that it won't move in line with share prices. With property funds investing in property directly, you get more of this 'diversification benefit'.
So SLI Select property is now my top choice in this sector.
As for the UK, our two Best Buy funds are likely to go on producing inflation-beating returns with low volatility, so they are still decent long-term propositions. M & G Property is the more blue-chip contender, benefiting from the backing of Prudential, while New Star Property has a more aggressive management style and will probably go on producing higher returns in favourable market conditions but with greater volatility.
Finally, if you are buying a commercial property fund for your SIPP, do not buy any of these funds because all are UK-based and suffer unrecoverable tax on their rental incomes. Instead, you need to buy an offshore-registered fund because then it can distribute its rental income tax-free and within your SIPP you won't pay tax on it either. Two of the best offshore funds are M&G Property and F&C Commercial Property.
Important risk warning - please read
The value of your investment and the income from it can go down as well as up and you may not get back a significant proportion of your investment. Past performance is not an indication of future performance. If you are in any doubt as to the suitability of an investment, you should seek independent financial advice.
