January 2008

The case for property

Over the past three to four years, fund management houses, in particular those closely affiliated with the pension and life assurance segments of the investment markets, have seen huge demand for UK commercial property vehicles. Unsurprisingly, this has led to new fund launches which aim to attract a more diverse range of investors into the asset class.

For clients whose remit dictates a well diversified investment portfolio which will be held for the medium to long term, i.e. five to ten years, then the case for holding commercial property is pretty much watertight.

Historic analysis highlights relatively uncorrelated returns as well as providing a secure income stream with typically lower volatility than equities. Despite some of the sales literature that potential investors may be presented with, returns from property can be negative and like every other asset class there will be periods of negative performance both in absolute terms and relative to bonds and equities.

Furthermore, many experienced property investors have amassed vast fortunes by adopting a long term strategy. One of the main drivers for this is that commercial property lends itself to the "buy and hold" approach and a significant element of the value resides in the land on which the property is built.

Few companies can consistently demonstrate growth over the very long-term because they tend to follow the typical economic life cycle of: growth, consolidation and then decline. Equity investors, therefore, need to change their portfolio holdings in order to maximise their returns.

Until relatively recently, retail investors had been unable to enjoy the benefits of commercial property through open-ended and un-geared investment vehicles. The wave of this new demand led the underlying vehicles to allocate their huge inflows into property related securities as well as in some cases, holding large amounts of cash on deposit or under short-term money market investments. As the fallout from the global "credit crunch" continues to unwind across the world's financial markets, investors have rightly become nervous over concerns that the current market volatility is a pre-cursor to a significant downturn in global economic prospects. Many have instigated liquidating their investment portfolios which has partially exacerbated the situation due to the large sale orders are forced into the market pushing prices down further in order to raise cash. Property fund managers have attempted to manage this by selling their most liquid positions first; using the cash balances and equity holdings first but as these dry up they are forced to effectively close funds to enable them to raise further cash.

Some smaller property vehicles are becoming forced sellers and this coupled with falling capital values, the relative attractiveness of other asset classes in particular Gilts during the recent volatility in the markets has led to some negative publicity over recent weeks. Comparisons have been made to the commercial property market's weakness in the early 1990s. This is rather unfair as during that period inflation was around 8% and at one point interest rates rose to 15%. This is compared to the current levels of approximately 2% for inflation and following the very recent cut, interest rates are at 5.5%, clearly the economic background is somewhat more accommodating.

At Origen, we continue to believe that investors should continue to allocate to property but should be prepared for some short term volatility although further sharp and significant falls in valuations are unlikely.

John Monaghan
Investment Manager
Origen