Portfolios

A piece of advice from the ever amusing and perceptive Mark Twain, I believe.

I have recently been looking at model portfolios offered by different investment advisers and funds investing in commercial properties like shopping centres, warehouses and office blocks are pretty much standard components of cautious or defensive models.

When I was in my early 20s and became a pension fund trustee, the pension fund advisers said we needed to buy some property to diversify from our portfolio of fixed income bonds and international equites. I read the proposal and noted that the income yield was about 4.5%. As other fixed income assets were paying about twice that, I could not see the advantages.

What was politely explained to me was that inflation in the early 1980’s was so high that the return on deposits and government bonds was in real terms negative. Because property values went up with inflation, so did the rent over time (unless you had no tenant, of course) and that was the merit of the asset. It was a hedge against inflation.

That is the main theoretical advantage of owning a portfolio of commercial properties. Commercial property has the advantage over private residential property in that the owner has much stronger rights over the tenant and rarely has to meet the cost of repairs, insurance and so on. Leases are also quite long, typically 9 years at least and sometimes much longer. Tenants may be ultra reliable, like banks or government departments.

So financial advisers put property funds in portfolios to get the steady income yield, the inflation proofing over time and there is also a limited degree of diversification.

But, that does not mean they are ‘safe as houses’. Commercial properties do not sell quickly, so such funds have to hold a lot of cash to meet withdrawal requests when people get nervous, or they have to impose restrictions on withdrawals. Holding cash when cash interest rates are low is a drag on performance.

Valuations are also not so frequent, maybe quarterly. And valuation is a matter of opinion if the property is not actually for sale. Comparisons with similar properties are made, so if the market gets into trouble there is contagion.

If valuations go up over a long period and economic factors mean that rents don’t, then yields are said to become ‘compressed’. That is usually a warning that valuations need to come down, because the asset class is becoming less attractive. I have seen that happen several times in my working life – there is a definite cycle.

Tax is an issue too as property fund income is taxable at source unless it is set up as a PAIF (a special type of fund structure) and that is not possible with conventional collective funds, only ISAS, SIPPS and other tax exempt structures. So non-taxpayers will lose 20% of their yield in some cases. After tax and expenses, some well known retail property funds are currently yielding not much over 2%.

With town centre retailers having a hard time, Brexit threatening distribution chains and foreigners not wanting to invest in Britain, the sector faces some tough headwinds. I would be avoiding it for the time being, but will always consider it as a portfolio component when the time is right.

Most investors in Southern England already own plenty of land (in value terms) and live on it!