Hot Property Goes Cold

Panic hit the commercial property market last week as a wave of sellers rushed for the exit.

Commercial property has enjoyed boomtime over recent years, helped by the recent introduction of REITs (Real Estate Investment Trusts), but the winds of change are blowing. As professional investors cut back their property investments, managers running some of the biggest funds began to impose exit charges of up to 7%.

The imposition of exit charges is a classic defensive mechanism employed by fund managers when the sellers come in hard. When significantly more people want to exit property funds than want to buy units, a fund manager can switch to lower 'cancellation pricing.'

These lower prices mean that the fund manager can cover the costs of selling physical property held by the fund. That said, a manager may have enough liquid assets to avoid having to sell any property but impose cancellation pricing nonetheless.

Scottish Widows' SWIP Property Trust has become the latest to alter pricing policy, following similar moves by Standard Life, New Star, Prudential, M&G, Scottish Widows and Norwich Union.

These price changes follow a fair amount of private investor excitement about commercial property back in January when REITs were launched.

Buying units in a REIT allows you to invest in a wide range of property without having to go through the aggravation and stress of buying into bricks and mortar. And if you want to get out again, the theory is that you simply sell your REIT units, which should be much easier than selling a house or a commercial building.

Ultimately the future performance of UK REITs depends on the outlook for UK commercial property values. The market has now taken on board the tax advantages of REITs versus conventional property shares. Now it's down to where property prices are headed.

Commercial property has performed extremely well over the last five years. Despite giving up almost 15% in 2007, the FTSE 350 Property index has produced a total return of 143% over the last five years, a 35% out-performance of the broader market FTSE 350 index.

Property agents Jones Lang LaSalle recently reported that UK real estate investment in the first half of 2007 exceeded £27bn, in line with last year. But with slowing inflows into UK retail funds and rising interest rates, they see a definite change occurring. Yields are rising and the number of bidders is reducing. They also report that UK REITs, including British Land and Land Securities, have 'rationalised' portfolios and have been significant sellers.

So what should property fund holders do now?

The past few years have been exceptional for commercial property where long-run returns have been in single digits. Sentiment amongst professional investors appears to have turned and industry commentators are predicting a leaner time. Jones Lang LaSalle is expecting a slightly lower level of activity during the remainder of the year. Fund managers are also now more cautious. Norwich Union sees future returns being more subdued than in recent years.

The risk is that those investors who feel they have overmuch exposure to commercial property may want to reduce it, irrespective of cost. The more investors head for the exit, the greater the pressure on the fund managers who are eventually forced into selling physical assets and driving down property prices which in turn prompts even more investors to bail out - a classic 'bear squeeze'.

Exactly how collective investment vehicles can exaggerate market volatility.

According to arch-bear, David Kauders of Kauders Portfolio Management: "Prime property yields have now fallen to the same level as gilts. There are now serious risks of investing in commercial property."

With all this bearishness around, a short term share price bounce is probably on the cards. But whether that will be enough to cover dealing spreads for the private investor is another matter. And while the threat of dearer borrowing costs persists, property prospects are likely to stay subdued even if there is no crash.

For genuine long term investors or regular savers committing fresh cash into property funds, the lower pricing basis makes it cheaper to buy in. But for those looking for shorter term performance, property shares and REITs look like an area to avoid for now.

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