Bricks and mortar

Examining new research, David Prosser shows why investment companies are the stand-out structure for investing in commercial property.

Although it does not suit supporters of either sector to say so, the investment company versus open-ended fund debate is an artificial one; the reality is that investment companies are a better option in certain circumstances for certain investors and the same can be said of open-ended funds. In the end, advisers and investors must pick the right fund for the job they want done.

That said, it must be acknowledged that there are certain asset classes to which investment companies are particularly well-suited. And in research published this week by Canaccord Genuity, analysts Alan Brierley and Ben Newell make the case for a stand-out example: the use of closed-ended funds to invest in commercial property. “We believe that the structural advantages of investment companies represent a competitive advantage and these underpin superior long-term returns,” the pair argue.

To see what Canaccord Genuity is getting at, cast your mind back to last summer, when sentiment in the UK commercial property sector plummeted following the unexpected vote for Brexit in the referendum on European Union membership. The headlong rush out of commercial property funds caused serious problems for open-ended vehicles, which had to find the cash to meet high levels of redemptions at very short notice; several funds had to impose penalties on withdrawals or even ban exits completely for a period.

Investors who wanted out of commercial property investment companies, by contrast, simply sold their shares. This didn’t do much for prices in the sector, but it had no effect on the underlying portfolio, so those who stayed invested were able to benefit from the recovery. 

It’s not just at times of crisis that this contrast makes itself felt. Open-ended funds feel compelled to maintain cash buffers to meet redemption requests from investors. In an illiquid asset class such as property, where you certainly don’t want to be a forced seller, managers know they need such buffers to manage the natural flows of cash in and out of the fund.

This isn’t a problem in an investment company, which is therefore able to maintain a higher level of exposure to the assets in which it is supposed to be invested. Compare a similar-sized investment company and an open-ended fund in the property sector and you’ll typically find the former has more invested in actual property. That’s presumably what advisers and investors want if they’ve decided to put money into the sector.

The effects, over time, can be dramatic.  Canaccord Genuity’s analysis of commercial property funds shows that over the past 10 years – a period including the financial crisis – shares in the average investment company have delivered a total return of 58.8 per cent. The figure for the typical open-ended fund is just 5.5 per cent. “A key factor is the higher exposure levels, with open-ended funds impacted by cash drag,” the analysts conclude.

If those figures don’t convince you, it’s also worth considering income. The yield available from property investments has been a major factor in the sector’s popularity in recent times, given the lack of income on offer from other asset classes. However, as on total return, investment companies tend to outperform. The average open-ended fund in the property sector currently yields just 2.9 per cent, which is below the 3.5 per cent on offer from the FTSE All-Share Index. The investment company average is 4.6 per cent.

This differential may be about to become even more important. Many property analysts believe commercial property is likely to offer only subdued returns over the next five years – in which case, income will be a more significant component of total return. That underlines the case once more for choosing an investment company for exposure to the sector.