The foundations are solid despite the façade looking shaky

Commercial property has long been regarded as a safe haven from equity volatility. But the thousands of investors who have piled into the sector in recent years have been rocked by a summer of bad news.

There are two main ways that retail investors have put money into commercial property: through quoted property company shares, such as tax-efficient real estate investment trusts (Reits) or companies listed in UK and Europe, or through property funds or bonds, which can invest in shares or directly into property.

Both routes have had a miserable time of late. Shares in property companies are now trading at lows that would have been unthinkable 12 months ago, with the industry’s big names such as Land Securities and British Land at discounts to net asset value (NAV) of more than 25 per cent.

Partly because of this, funds investing in property shares have also had a torrid time. Funds that concentrate on direct property holdings have not performed much better, owing to values for commercial property reaching, or nearing, a peak.

Analysts believe that prices for most commercial buildings in the UK are as high as they will get in this cycle. Investors now need to face up to the fact that yield compression – where returns have grown purely because market values for property have increased – for commercial buildings is now over.

Last week, figures from the Investment Property Databank, the industry’s research provider, showed the lowest monthly return from the sector for 12 years. Average total returns – rent plus capital growth – were just 0.2 per cent in July, after several years of annual returns of up to 20 per cent.

The turning tide of sentiment has most obviously manifested itself in the recent increase in money outflows from many UK property unit trusts.

The flow of money out of UK property funds doubled in the second quarter to £641m, according to the Association of Real Estate Funds. This week it emerged that Norwich Union had cut the prices of two property funds – its £2.6bn Property Life fund and its £1.2bn Property Pension fund – for a second time in August. This follows on from a first round of price cuts to stem redemptions as more investors were exiting than joining. Funds run by Resolution, New Star, Standard Life, M&G and Prudential all followed. Winterthur, the insurer, estimates that there has been a 50 per cent drop in inflows into property funds since July.

Commercial property auctions, often seen as a bellwether for the wider property industry, have also shown signs of a struggle, with the £718m raised in July down 11.7 per cent from July 2006.

If you have money in commercial property funds, and are wondering whether you should withdraw it, the message from financial advisers is to sit tight. Justin Modray at Bestinvest says: “Over the long run the performance of UK property will be sound, particularly in the better placed funds such as Scottish Widows’ and New Star’s.”

Also, amid this gloomy backdrop, property investors are still finding opportunities, not least because capital appreciation is only half the story. The strategy most UK funds and professional investors are pursuing rests on the UK rental market, which most indicators suggest is still rising.

The key is picking quality, says Stuart Webster, New Star’s head of global property. “The fundamentals are still good. If we stick to quality then there will be strong returns relative to other asset classes.

“If you secure good tenants in a limited supply market then there is income plus capital growth still. People forgot to price in risk for a while in the hysteria of the bull market, and forgot about this need for quality.”

This is the strategy being pursued by the Invista Foundation Property Trust, for example. Nick Montgomery, head of UK-listed commercial funds, says the 20 per cent-plus returns of the past few years are over, but there is still a decent income from the sector.

“Clearly there is a slowdown in the market but returns were not sustainable. We gave an NAV return of 22.4 per cent in the year to June, when investors were expecting 8 per cent. Now, we’re still saying we’ll meet that 8 per cent or more.”

Montgomery says the fund will need to be “more agile”, looking at ways to manage, develop and improve buildings to increase their value, selling what it can’t and buying into more defensive properties with a minimum fixed uplift on rents.

Richard Jones, head of life property funds at Morley Fund Management, can see a similar strategy for the property owned by its £14bn of funds under management.

“We’re in a transitional period. There has been a lot of hysteria about returns not being at the exceptional numbers of the past three years, but they are just returning to more normal and sustainable levels.

“Income will be the main driver for returns over the next two or three years with scope for capital growth based on securing rental increases.”

While funds will depend on their skills to make money, rather than just market movement, analysts also see improvements in the quoted property sector, which many see as oversold given the fundamental strength of assets behind some of the bigger property companies.

Harm Meijer, an analyst at JPMorgan, believes the market is showing signs of value, saying “the market is pricing in a real disaster”.

Most agree that property remains a sound long-term addition to an investment portfolio. Gareth Lewis, director of investment at the British Property Federation, says: “It is still a key diversifier. If people said it was a good time to get into property in January, now must be a great time as you can pick up real value.”

However, Meijer warns that the share sell-off might not be over yet and so urges caution before putting more money into property equities. “Would I rush back in? No. It might be oversold but it is going through a transitional period from bull market to modest growth and there is a shake-out still happening.”

In the meantime, many investors are looking outside the UK, Meijer says, to find better returns in markets going through different points in the cycle.

According to Jones Lang LaSalle, the property agent, capital flows from the UK into commercial property in Europe have been more than £8bn since January.

New Star’s recently-launched global property vehicle has provided another mainstream route for investors to gain exposure to this market. The New Star International Property Fund has a higher yield, at 4 per cent, than its UK Property Unit Trust at about 3.6 per cent.

It is understood that the fund took in as much as £3.7m in one day last week, and can expect an average of between £1m and £4m a day, which is a remarkable intake given the choppy state of the investment market.

Paul Craig, fund manager for New Star’s fund of funds Global Strategic Capital Unit Trust, says he has targeted overseas funds for better returns. “The funds we have picked are in overseas property, in places like Macau. Sentiment to UK property has changed,” says Craig.

There are a huge number of property funds and companies that invest in a wide variety of regions and sectors, many listed on the Alternative Investment Market (Aim).

Investors should be cautious as some of these represent the new frontier for property investing, in less well-established countries and sectors outside the norm, from caravan parks to garden centres. As such, many promise higher returns but at a much greater risk.