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CHALLENGING TIMES FOR PROPERTY FUNDS

Property has traditionally been one of the four main asset classes together with equities, bonds and cash within a well-diversified portfolio designed to reduce volatility and manage risk. However, things have changed significantly in recent years especially since the coronavirus pandemic started to hurt the economy just under a year ago.

In an earlier blog, I expressed my pessimism about bonds over the coming years because once interest rates start rising inevitably the value of bonds will fall. As for cash there is no point investing in cash other than to pay management fees because once you deduct charges your return will be negative because interest rates are virtually zero.

By property funds, I am referring to commercial property which consists of three property sub-sectors namely retail, office and industrial.

The retail sector was already facing challenges with the inexorable rise in online shopping but the lockdown has decimated the sector. Many retailers will close their businesses forever. It looks likely that there will be less retail properties in future. I expect to see a lot of retail to residential property conversions especially since the commercial property planning laws have now been relaxed so much.

Offices have been badly affected too because office staff have got used to working from home and using video conferencing for meetings. Companies have experienced greater productivity from their home-working staff and that has certainly been my personal experience and anecdotally. Many companies have decided to close their offices for good and employ permanent home-working staff.

Industrial units have been temporarily affected due to lockdown but they should recover once we get back to the new normal whatever that may be.

Property funds, by which I mean OEICS (Open-Ended Investment Companies) and unit trusts, have also faced a challenging time with high demand from investors to sell their investments at the start of the pandemic which led to property funds having to be suspended. This meant that most investors were unable to cash in their property funds until around October last year. The reason for this is because of the structure of such funds which are known as open-ended. What that means is that when there is high demand to withdraw money these funds have to sell their underlying assets. The trouble is you cannot sell an office building overnight if there are tenants renting it under a long term lease. Even if the property is empty it could easily take months, if not years, to sell it. Usually, this isn’t a problem because property funds have good cash buffers but where there is high demand to encash the money the fund cannot meet that demand immediately in full so they suspend dealings in their fund until everything gets back to normal. So in other words OEICS and unit trusts invested in property are illiquid investments.

Commercial property has been a good asset class for decades because it isn’t highly correlated with shares. Also, such funds usually generate relatively high rental yields and traditionally they have had long term leases with upward only rent reviews. Commercial property performs well when the economy is buoyant.

Although property funds face a number of challenges currently we do not believe all is lost for the sector. We will be offering property investment in our newly launched discretionary fund management service with Transact. However, we will not be offering OEICS or unit trusts. Instead, we will be offering REITS (Real Estate Investment Trusts). The advantage of REITs is that you can buy and sell the shares without having to sell the underlying assets, in other words the properties, so they are liquid. That’s because such structures are known as close-ended. The disadvantage is that REITs are more volatile than property OEICS and unit trusts. Nonetheless, all of these structures are capable of investing in the same property assets.

We do believe that certain sectors of the commercial property market have positive prospects such as the following selective examples;

Data centres

Energy centres

Warehouses for storage and distribution of online orders

Serviced offices

Automated manufacturing centres using robotics and AI

Offices will continue to exist but it is likely that demand will decline.

Certain specialist High Street retailers will continue to thrive such as the best restaurants, pubs, hotels, hairdressers and nail bars. That’s because there are many services that cannot be experienced online. Only the very best will thrive and they will have to have a good Internet presence to back up their face to face service.

So we will continue to recommend property funds but only REITs and even then only selectively if we believe they are invested in commercial property with true growth prospects. You know it makes sense.

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