Property funds: safe as houses?

Investors wishing to profit from property prices and rental yields don’t have to buy a house, when they can invest in property funds instead. Rather than heading to an estate agent, try an investment platform. You can snap up a stake in a property fund with much less money and hassle than buying a building.

Why invest in a property fund?

Traditionally, property funds provided a solid foundation stone when building a diversified portfolio, to balance out fluctuations in equities and bonds. In addition, property funds investing in bricks and mortar can also provide a more reliable source of income than some equities, based on a combination of rental income and capital growth. Income yields are not as high as the 4%-5% before the financial crisis in 2008, but it is still possible to earn around 2% a year.

Many property funds look beyond residential houses and flats to commercial property, such as offices, shops, factories, hotels and hospitals. Commercial tenants on long term leases such as major companies, big banks or governments can be a great source of strong, sustainable income.

A bit of history

The oldest property-owning funds were established by big pension providers and life insurance companies, including Aviva, Scottish Widows and what were then Aberdeen and Standard Life.

Interest in property funds picked up after 2000, when the tech bubble burst and the stock market slumped. From 2005 onwards there was a flurry of property fund launches after it was announced that funds investing in commercial property could be held in Stocks & Shares ISAs.

Major players in UK property funds today, alongside Aberdeen Standard, include M&G, Legal & General, Janus Henderson and Columbia Threadneedle.

Meanwhile real estate investment trusts (REITs) were introduced at the beginning of 2007, after the success of these tax-efficient structures in the US, Japan and Australia. REITs typically invest in physical property and, just like other Investment Trusts, are companies in their own right that are listed on a stock exchange. They are required to pay out 90% of their rental income as dividends to investors, in addition to any growth from property development and rising property prices.

Pick your structure with care

In theory, whipping your money out of a property fund should be much quicker and easier than mortgaging a house or putting it up for sale. However, in reality it depends on the type of property fund you are invested in, as many investors have found out at great cost and frustration. So why is that?

The trouble lies with the open-ended fund structure, which can cause a “liquidity mismatch”. What this means is that whilst technically investors can buy and sell units of the fund daily, the underlying properties take way longer to sell.

The result is that if loads of investors want to sell their investment at the same time, the fund manager may be unable to sell properties quickly enough to pay them all and be forced to suspend trading in the fund for a while.

To manage this risk, many funds invested in physical property hold a healthy chunk of cash on their balance sheets to cope with redemptions – another reason why their performance may move in a different direction to equities – but depending on the scale of the redemptions, this isn’t always enough. It is a tricky balance between having enough cash to cover redemptions but also staying as fully invested as possible, to maximise returns.

Access denied

Several of the UK’s biggest commercial property funds were suspended after the Brexit referendum as they were unable to cope with the volume of investors keen to cash in their units.

Some property funds were again suspended after COVID-19 hit - not because of mass redemptions, but because the pandemic made it impossible to value properties, partly because surveyors could not get out for valuations during lockdown.

Currently, the city watchdog, the FCA, is reviewing proposals that would require investors in open-ended property funds to give between 90 and 180 days’ notice before redeeming their investments. The change aims to stop recent runs on property funds and make it less likely that open-ended funds are forced to suspend trading. It could also improve performance as property funds could invest more of their assets, rather than needing to hold up to 30% in cash, to meet potential short-notice redemptions.

But will this rule simply make open-ended property funds uninvestable? Investors expect to be able to buy and sell their investments whenever they want, so requiring advance planning could push them to move their money elsewhere.

Furthermore, the current FCA proposals would require investors to request a redemption, which would then be processed at the end of the notice period. Investors therefore wouldn’t know how much they would end up getting for their investment, as the price would be based on the valuation after the notice period, rather than when the money was first requested. These rules would lead to a lot of additional uncertainty for the investor, which would have to be considered carefully before investing.

HM Revenue & Customs has also warned that if the proposed notice periods go ahead, new open-ended property funds would not be allowed in Stocks & Shares ISAs. Investors may however be allowed to hang on to any investments already held in their ISA.

But there is another way

So, does that mean that you just have to give up on the idea of investing in property funds unless you are willing to take these risks? Not necessarily.

Enter REITs. Because REITs are structured as close-ended funds there is no risk of a liquidity mismatch. And indeed, many experts argue that closed-ended funds such as Investment Trusts and REITs are more suitable when investing in illiquid assets, such as unlisted companies and property.

In addition, just like other Investment Trusts, REITs are allowed to take on gearing, which can boost returns in good times (although it can also exacerbate losses in downturns).

It is not a bullet-proof solution though (is there ever?).

As with any other stock, if investors rush to sell the shares, the price is likely to drop far and fast. But at least you will still be able to sell your stake, and the fund manager won’t be forced to sell properties within the fund. Sometimes it is better just to get your money out, even at a loss, compared to the long-term opportunity cost of having it locked up.

Know what you are buying

As with any other investment, it is vital to understand the fundamentals of the fund and what that means for potential risks and returns. In the case of property funds, the first thing is the structure: open or closed?

Second, does the fund invest in bricks and mortar properties, or shares in property-related companies, such as housing developers? These are the key questions to consider when investing in property funds.

You can then start to think about the type (residential, commercial, etc) and location of property you want to focus on. There is a wide range of options available, from global commercial property funds to country specific residential property funds, and everything in between.

Property funds provide a low-cost way to profit from property prices and rental yields, with the tempting promise of diversification and reliable income. But not all property funds are the same, so don’t assume your money is necessarily safe as houses. It will come down to the structure of the fund, how it accesses those properties (direct or via shares), and the type and location of those properties.

Just as if you were buying a property to live in, do your homework to discover the most suitable property fund to house your savings.

Date of publication: 3rd February 2021