Is Property Still Profitable?

Commercial property has enjoyed a strong run in recent years, but as analysts predict plummeting returns this year, has the bubble burst?

You can't really overstate the popularity of property investments with UK investors. When you think about it, you probably picture a lucrative residential buy-to-let opportunity. But this isn't the only way to gain exposure to property. Commercial properties such as offices, industrial buildings and retail space are an alternative route which has posted some impressive returns over the last few years.

Unlike residential property, purchasing a commercial property directly is well beyond the reach of most ordinary investors. Instead these assets are opened up to us by investing in a property unit trust where our money is pooled with other investors and used to purchase properties collectively. More and more of these funds have appeared on the market over the last year or so to meet burgeoning demand.

When any asset performs particularly well it's bound to capture the attention of investors, and it's equally true of commercial property. Investors have piled in, keen to capitalise on runway returns. According to the Investment Property Databank (IPD), last year commercial property produced a total return of 18.1%. This even outperformed residential property, which stood at 16.8%.

But, more recently, the sector has experienced its fair share of difficulty and investors have begun to abandon commercial property funds now the outlook isn't quite so rosy. Analysts generally agree, in a normal cycle, that property should produce growth of around 7% or 8% a year. A return to normality must surely be expected sooner or later and it seems the time to wave goodbye to double digit returns may already be upon us.

So this leads us to ask: Is it worth taking the additional risk of investing in property if the expected returns are heading for a fall? I think it would be helpful to take a look at the figures here and compare commercial property with other asset classes.

Property Versus Other Assets

Source: Investment Property Databank (IPD). IPD UK Monthly Index: To End July 2007

The latest IPD data shows that over the last twelve months commercial property returns have fallen short of equities (shares) by less than 2% while outstripping gilts (fixed income assets). Despite the doom-mongers, for the year to date property comes out on top. But sadly, I think it's fair to say it's unlikely commercial property will rally over the remaining months of the year to match the returns achieved in 2006.

That said, I don't think it's too late to consider investing in commercial property funds as long as it's part of a well-balanced portfolio and you're looking to invest for the long haul. Property performs an important function by having a low correlation to equities which, generally-speaking, means when equities are performing poorly, conversely property assets tend do well.

But the commercial property story doesn't end here. I mentioned property unit trusts earlier but to complicate matters, there isn't just one type. Property funds come in all shapes and sizes so you need to be aware how much risk you're taking on when you invest.

First of all, let's take a look at direct property funds. Direct property funds purchase `bricks and mortar' properties which are held within the fund as tangible assets. Direct property funds tend to have a low volatility since its pricing primarily changes in line with any movement in the underlying valuation of the property portfolio.

Alternatively, you could consider property funds which invest in property securities (shares) or Real Estate Investment Trusts (REITs). These funds hold shares in a portfolio of property and property-related companies rather than holding property as a tangible asset.

Just to give you a very brief background, REITs were launched in January as a tax-efficient way of investing in property. Unlike other property companies, they're sheltered from corporation tax on chargeable gains and rental income although shareholders will still be charged income tax on dividends and capital gains tax. They're designed to broaden the choice for the individual investor while side stepping the cost and hassle of investing in bricks and mortar.

Like direct property funds the pricing of REITs and property securities are influenced by changes in the underlying commercial property market but they're also subject to market speculation and the functions of supply and demand and therefore tend to be significantly more volatile and hence more risky than direct property funds.

If you feel like being really adventurous you could invest in a single REIT or property company. Some UK property companies have converted to REIT status including British Land, Hammerson and Slough Estates.  Essentially if you invest in a single REIT you'll hold shares in a single company, which obviously is a more risky venture than investing in a pooled fund which provides exposure to a number of REITs.

If you decide you want to invest in commercial property, you need to look closely at the fund's holdings. Make sure you don't inadvertently choose one which has a 100% exposure to property shares if you want to use property as a hedge against your holding in equities. Some funds combine both strategies with a quantity of cash for liquidity purposes. The composition of the fund should be easy to come by from the fund management company.

Regardless of which type you choose, arguably the glory days for commercial property may already be behind us. But when it comes to building a balanced portfolio, diversification is the name of the game and I reckon commercial property still has a part to play in that.

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