How do you invest in property?

All investors who own their own home are exposed to the residential property market. However, there are a number of investment products that offer access to different sectors of the broader asset class.

It is possible to buy funds that invest in residential property, which offers you exposure to the same sector as your house, albeit diversified across a number of properties.

Commercial property is a more popular sector, which essentially involves investing in the land and buildings rented by companies.

Investors have to decide whether they want to invest in bricks and mortar funds, which own the buildings they invest in, or property share funds, which own the shares of companies that own the buildings.

You can hold a property fund in an ISA or a pension, which is not the case with any property you directly own.

More so than most asset classes, what you get with a property fund depends on the structure of the vehicle you use to invest.


Why invest in property?

Historically, property has been used as a way to diversify away from equity and bond exposure and to provide an income as well.

It may well turn out to be a good diversifier again in the future, but over the past few years, following the 2007 crisis, the sector has been increasingly correlated to the other main asset classes.

In capital growth terms, investors have seen losses over the past few years, following a decade-long housing boom. The market has been stronger in south-east England and London.

However, all sectors have poor years, and the financial crash has not destroyed the case for investing in property once and for all.

Property continues to provide a way to diversify your income stream, and with the high importance placed on income by today’s investors, this means it has to be considered.

The sector continues to provide attractive yields. Funds distribute the income they receive in rents to investors, who are taxed at their normal income rate.


Funds

Property funds have some problems that stem from the nature of the asset class.

Property is a highly illiquid asset, meaning that selling can be difficult when the market turns for the worse.

Furthermore, it is expensive to buy and sell a property thanks to taxes, legal fees and agents fees, meaning that any returns a fund makes are trimmed down by this.

The transaction costs are very high. Daily trading is not always possible and costs can be up to 6 to 7 per cent of the returns of the fund.


Open-ended funds

These issues are compounded in an open-ended fund, which has to be able to return money to its investors if they decide they want to cash in their units in the portfolio.

Given it is a slow process to sell a building, this can cause real problems. In an extreme situation, the manager may have to impose a notice period for redemptions, requiring investors to wait to withdraw their money until the property has been sold.

Open-ended funds need a good cash buffer to handle redemptions, which means a lot of money is not invested, hitting returns.

Many advisers say that the open-ended structure is not the best way to get exposure to the asset class.

Open-ended funds cannot hold more than 15 per cent of the fund in any one property, and are also restricted in the proportion of the fund that can be held in leases of less than 60 years, or in mortgaged property, which limits the gearing they can take on.

Another peculiarity of the asset class is how it is valued.

Property valuation is subjective, being based on people’s opinions and the valuations of similar properties in the same area.

A fund can revalue its holdings, which can lead to a big jump or fall in its value.

This means that when property is out of favour as an asset class, this can lead to sudden falls in value that can be alarming for investors.

As the graph below shows, however, investors would be better off putting their money in property funds over the long-term rather than buying a house and waiting for it to appreciate in value.


Shares

Another option for investors is a fund that invests in the shares of property companies.

They move like a traditional equity fund, but invest in property companies or those that own property assets such as listed companies that own office or retail space.

These do not suffer the problem of redemptions that open-ended funds holding bricks and mortar do: if investors want their money back, they can simply sell the shares they own.

They behave more like equity funds because they are investing in listed shares: it is not the same as holding direct property as the price will depend more on the underlying stock market.

This means that investors lose the low correlation to the stock market that bricks and mortar displays in the normal course of affairs.

These funds are the best-performing in the IMA Property sector over the past three and five years, but they tend to be international in scope, either investing globally or in fast-growing economies in Asia.


Closed-ended funds

Closed-ended investment trusts also invest in the shares of property companies, which means they do not suffer the same requirement to hold back money against redemptions.

Because they issue shares that trade on an exchange, when investors sell an investment trust, the manager does not have to sell any of their assets – it is the share price that is affected.

Trusts can also borrow money to increase the amount they can invest. For a list of all the other characteristics of investment trusts, see this earlier FE Trustnet article.


REITs

Since 2007, a company that runs properties can register as a "real estate investment trust", which brings with it tax benefits.

A REIT does not have to pay corporation tax on any capital gains or income it makes on its properties, which means that the only tax paid is by the end investor.

This gives it an advantage over open-ended funds, although a REIT is required to pay out 90 per cent of its gains as income to retain these tax privileges.

A REIT will withhold 20 per cent of tax at source – the basic tax rate – and its shares are traded on an exchange.