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Property: alternative investment or tried and tested asset class?

Richard Willsher is a freelance journalist specialising in finance.

Research suggests that investors are increasing their exposure to real estate. But if that's where the hot money is going it's much less clear how to invest, where to get advice and who to work with for the best results, says Richard Willsher

In their 2004 World Wealth Report Cap Gemini and Merrill Lynch show that high net worth individuals have increased their real estate investments from 15% to 17% of their portfolios. London-based Tulip Financial Research also found that together investment property and property funds received a similar allocation. Over the last couple of years this seems to have happened at the expense of cash and fixed income allocations but not lately as a refuge from falling equity markets, which seems to have been the case up until the end of 2002.
 
"Property has always been a major asset class for private individuals," says Catherine Tillotson, a partner at the Scorpio Partnership, a strategic wealth management consultancy that advises private banks and wealth managers.

"For a number of reasons, such as private residences, holiday homes or business premises, wealthy investors have tended to have a strong concentration in property. The difficulty that their traditional advisers such as banks and wealth managers have had has been that they find it difficult to come to terms with the asset class. It is not as liquid or as freely tradable as equities or bonds, for example."

This is a view shared by David Kilshaw, a private client partner at KPMG. "I've found that wealth management advisers will present to their clients on asset allocation, focusing on equities and fixed interest but generally are not very clear about property. For the client it is therefore more difficult to access property expertise."

Direct real estate investment
So what are the alternatives? The first is clearly to carry on investing directly in property. Buy more homes, buy more holiday retreats, invest directly in commercial property such as light industrial units or office accommodation. One attraction of this route is that the investor can see his property, visit his investment and keep a close watch on it. Assuming that such property generates rental income, then cashflows from it can be pretty reliable while the capital gain brings additional benefit. In addition, local or specialist knowledge, chance conversations or one-off deals can produce exceptional opportunities.
 
The downside comes from the administrative burden of managing directly held property. Finding trustworthy tenants who pay their rents on time and keep to their covenants can be a chore. Protecting the property from fire, theft and other perils presents a cost. Employing a property manager is one way of dealing with these issues. Indeed one of the functions of a family office could be to manage direct real estate holdings.
 
Kevin Ruth, director of financial planning, UBS Wealth Management in New York, also points to the issue of what happens when the property owner dies. "In the US, when there's a death and a transfer of wealth from one generation to the next state taxes are due and they have to be paid in cash within nine months of the death. So real estate that cannot quickly be turned into cash can cause clients to have to carry out fire sales of their real estate and not achieve full value. One of the things we look at is what you do if you have to immediately sell real estate should something happen." Balancing more liquid and illiquid assets within a portfolio is clearly one approach. Carefully planning the ownership of the property at the outset is also an important consideration.

Private funds
So there are pluses and minuses to investing directly in real estate but there is no question that this has retained its appeal over centuries. A second route would be one of joining a restricted pool of like-minded investors. Typically these could be formed in the context of a specific development, residential or industrial, perhaps being assembled by a property consultant or developer. The advantages of being able to see and to visit you investment are still to be had but hopefully the property will be properly managed by third parties who take care of all of the burdensome aspects of the directly held property.

There may still be associated risks and concerns. Chances are that the property may still be illiquid and what are the terms by which an exit from the investment can be achieved? Would a replacement investor need to be found and if so how and how long would it take? Locating such investment opportunities in the first place may not be easily achieved and obtaining good advice as to its future prospects will require careful due diligence from trusted advisors.
 
The perennial problem of buying illiquid real estate continues to dog the direct investor. The returns may well be worthwhile but it still bears the hallmark of the 'alternative investment' asset class – tangible and even pleasurable to own perhaps but relatively high risk and probably long-term and easy to get out of when the going gets tough. But as Scorpio Consulting's Tillotson says, "It's important to know why you are investing directly in property. Perhaps you have an interest in investing in a particular location, for example, but that is very different from simply getting exposure to the asset class. In that case another vehicle might be more appropriate."

REITs
Real Estate Investment Trusts (REITs) have proved hugely popular as a means to investing in property, particularly in the US. There legislation to allow the public to invest in commercial property was passed 45 years ago. According to figures from the US National Association of Real Estate Investment Trusts, in 2004 there were over 200 publicly-traded REITs with total assets of $275 billion. Other countries have now adopted similar vehicles. Australia is one country where investment in listed property trusts is common and there are 50 listed property trusts (LPTs) on the Australia Stock Exchange with reportedly 800,000 investors – remarkable in a country with such a relatively small population. Hong Kong is another market where REITs have proved popular.

In Europe, France introduced Société d'Investissement Immoblier Cotee' (SIIC) vehicles in 2003 and in Belgium SICAFI arrived in 1995. A number of other countries are considering introducing REITs including the UK where property investment funds have been debated for some time but look unlikely to be introduced before 2006 at the earliest.

The key feature of REITs, apart from their ease of access as public traded funds and their liquidity, is their tax efficiency. Their founding legislation exempts them from paying tax at the corporate level provided they distribute most of their income to investors in the form of dividends. This avoids an effective double taxation, as investors will then only be taxed on their own income in the ­conventional way.

Property funds
In the UK, Mike Samuels, a director at Kleinwort Benson Private Bank and its head of real estate advisory, notes that some of the listed property funds can be quite attractive, though not as tax efficient as REITs. There are currently seven of these and one which Samuel's clients have invested in, among others, is the Teesland Advantage Property Income Trust Ltd. The trust invests a selection of commercial and industrial properties outside London, where the investor gains exposure and they are well-managed by a manager with a proven track record. The investor has liquidity because these trusts are listed, not only in London but also in the Channel Islands, which may suit some investors.  

In addition there are unlisted funds which are usually assembled by property specialists and provided through investment banks where it is possible to invest in some of the newly emerging property markets, perhaps in central and eastern Europe or the Far East. These funds are more akin to private equity arrangements and caution needs to be adopted in choosing such markets. The key to success is to work with a partner who has a good knowledge of the local market and understands its risks and opportunities.

Inevitably, there is the usual trade off between risk and reward. Mike Samuels notes that while it has certainly been possible to gain high returns from commercial property over the last couple of years it is important to recognise the highest rewards often come at the expense of a risk to equity. Therefore he advises investors to look for lower yields that could be in the range 5-6%. With capital appreciation this is likely to add up to a better investment than going for high yields. "Beware," says Samuels, "of high yielding commercial investment because it will be a risk to your equity."

It is also characteristic of the current property investment environment that investors tend to use leverage to gear up their return. Typically it should be possible to borrow 65% of the purchase price of a property at quite low fixed rates providing a good level of equity return after interest costs.

There is nothing new about property investment. Wealthy investors have felt comfortable with it for generations, especially on a direct ownership basis. With the spread of property investment trusts, and particularly REITs, it is clear that more and more funds will find their way into the commercial property sector. This brings with it rewards and risks. There will be some who say that the best of the property market has already come and gone while others will say it still has plenty of potential for good returns. Good, impartial advice will be critical to understanding where along this curve we are currently sitting.

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