Investors are often attracted to commercial property funds, but the asset class comes with its fair share of risks. In this article, we evaluate some of the advantages and disadvantages of investment in commercial property.
Types Of Commercial Property Funds
There are two key types of commercial property funds: direct and indirect property funds.
Direct property funds are the most popular and buy commercial real estate such as industrial and retail parks as well as office blocks. Investors should be able to rely on a reliable rental income from these properties and potentially benefit from any capital appreciation.
Money invested in this type of fund is spread across a variety of different properties. This strategy helps with diversification and means that if one or more properties are unoccupied for a period of time, the others can still bring in an income.
Indirect property funds invest in the shares of firms that operate in the property and property development sector. Their performance, therefore, tends to be more greatly linked to the wider equity market.
If you want more flexibility then there are funds that take a hybrid approach and allow you to invest both in direct property and in property-related securities.
The key benefit of property funds is that they can provide a good source of income for investors, while also offering an extra layer of diversification.
How property funds are structured
Property funds can be structured in two key ways: they are either closed-ended, such as property trusts or real estate investment trusts (REITs) or open-ended, such as unit trusts or open-ended investment companies (OEICs).
OEICs are incorporated as a company and will issue shares while unit trusts are established as trusts and will issue units to investors. The fund manager buys back units or shares from investors wishing to leave the fund.
The financial value of the units or shares in a unit trust or OEIC increases or decreases based on the value of the assets which underpin the funds. Most funds are valued only once per day, and this establishes the daily price at which investors may buy or sell units in the fund.
The other main type of property fund, closed-ended funds such as investment trusts, are stock market listed and traded like stocks.
These shares don’t face the same type of liquidity issues that open-ended funds have to deal with because they can be traded throughout the day. When an asset is considered to be ‘liquid’, it means it should be easy to sell at a fair price. Conversely, property is viewed as ‘illiquid’ when it is difficult to sell quickly at a reasonable price.
If investors want to sell closed-ended funds, they simply sell their shares, but when investors want to sell their holdings in open-ended property funds, the buildings underpinning the fund have to be sold.
Closed-ended funds issue a set number of shares, so once these are all in circulation, investors must purchase them on the market, as they would with any other stock.
What Are The Risks Of Commercial Property Funds?
Property funds pose two significant risks. Primarily they can be a highly illiquid asset class, making them difficult to sell quickly at the right price and coupled with these, property values can be very volatile.
Serious problems can also arise when a very large number of investors decide they want to cash in because unlike other property funds, commercial funds do not hold a proportion of the fund as cash to meet investor redemptions.
In this situation, where the manager of an open-ended fund doesn’t have a large enough cash buffer in place, they’ll have to sell some properties so they can reimburse exiting investors and this can be a slow process.
For example, following the referendum on Britain’s membership of the European Union, many investors got nervous and started to withdraw their money on the back of concerns that a departure from the EU could have a negative impact on commercial property prices.
This also happened during the global financial crisis of 2008, when UK commercial property values plunged and large numbers of investors attempted to withdraw their capital at the same time.
On both occasions, investors moved to cash in their holdings at the same time meaning a number of open-ended funds had to be suspended.
Investors were unable to sell their holdings and fund managers stopped repurchasing units and shares. Under such circumstances, investors can’t do anything and need to stay put until the suspension is lifted. Investors in suspended funds do, however, continue to receive income from the portfolio.
What About ‘Fair Value Pricing’?
Fair value pricing is not always in the interests of investors looking to redeem their shares.
The term essentially means a fund manager makes changes to the value of their assets based on their estimates of the current likely values of the fund’s property holdings if they have to be sold at short notice.
The ‘fairer’ transaction price takes account of the fact that properties coming to market now may not achieve recent valuations.
The central aim of this is to restrict sellers from redeeming too high a value for their shares, which would impact long-term investors in the fund.
The secondary impact is that when investors want to cash in their investments, fund managers aren’t forced to sell the buildings they invest in at short notice. This could mean they’re unable to get as high a price as they would if they were able to wait.
For investors locked into suspended funds, even when the restriction is lifted, they could find that fair value pricing has been applied and they’ll need to decide whether or not they want to sell their holdings at a discount.
As the shares in closed-ended funds, such as property trusts and real estate investment trusts (REITs) are listed and traded like stocks, they don’t face the same liquidity issues that open-ended funds have to deal with.
If investors want out they can sell their holdings more easily – they simply sell their shares. However, listed property funds can see their values fall steeply if the sector takes a bad turn, as can open-ended funds that invest in property company shares. Commercial property is still generally viewed as a good way to diversify business despite the risks involved.
PLEASE NOTE: The value of investments, and any income from them, can fall and you may get back less than you invested. Neither simulated nor actual past performance are reliable indicators of future performance. Information is provided only as an example and is not a recommendation to pursue a particular strategy.