HSBC Private Bank (UK) Limited

Commercial property is certainly hot at the moment – too hot some would say. Over the last decade, total returns from property have exceeded those from just about any stock market. However, most private investors, despite having portfolios stuffed with equities and bonds, have little – or nothing – in property of any sort other than the house they live in. Rather strange for an asset class that is estimated to be worth US$4 trillion worldwide, equating to 26% of global investment wealth*.

The reason for this state of affairs can probably be summed up in two words – liquidity and size.

Whichever way you cut it, property ownership is illiquid. The process of buying and selling is both laborious and expensive – and values, as a result, lack transparency: a FTSE 100 share will be traded thousands of times a day, a landmark building maybe once in ten years. As for size, any building that has a financially strong commercial tenant rather than a “Mom & Pop” business is likely to be worth at least £5m – which puts it outside most private investors’ wish lists, unless of course they are property professionals, extremely wealthy or are prepared to throw aside any conventional diversification. Some pension funds, as a result, won’t look at direct property investment unless they have north of £100m to invest in buildings. It is worth noting that UK institutions reduced their property exposure from an estimated industry average of 15% in 1980 to an estimated industry average of around 5% in 2000. This trend is now in reverse with big implications for prices.

To address this dual problem of liquidity and size, the sensible route for the private property investor has been to go down the collective route – to buy a property fund or shares in a property company. Neither of these routes has been without its issues, as the sad truth is that liquidity comes at a price – and that price is performance. The Holy Grail is liquidity and performance – and is as difficult to find as the Holy Grail itself.

In the case of companies, investors in search of income have been hit by the dual problem of double taxation and property company management. Double taxation occurs when rental income is taxed first in the form of corporation tax, and secondly as it hits the investor’s wallet as income tax on dividends. The problem with management is that it is often expensive and sometimes can’t resist the temptation to take too much risk with investors’ money through development. The result has been an income profile from quoted property companies that has been less than exciting and a portfolio of properties that can be difficult to define as either “income” or “capital gain”.

There are also investment trusts (closed ended companies with a fixed number of shares) and unit trusts (open ended funds with a fluid number of units). Investment trusts have two main problems. The first is that they have traditionally traded at a discount to net asset value and the second is that they are correlated to what happens in the stock market (as are property companies’ shares): one of the reasons that many investors buy property is to own an asset that doesn’t mimic the rest of their portfolio. This can be a real disadvantage.

In order for unit trusts to offer liquidity they have to keep a sizeable proportion of their assets in cash to be able to deal with investor redemptions – sometimes up to 20% – which again has an adverse impact on performance.

At this liquid end of the property spectrum, there is now a partial answer to these issues (for the income investor anyway) in the form of Real Estate Investment Trusts or REITs. This structure means that, as long as the (large) majority of the rental income is paid out to the shareholders and that only a (small) proportion of the assets are in the form of development stock, the income is taxed only once. As they are transparent and geared to income, their characteristics are more bond- than equity-like and, while they are not entirely uncorrelated to the stock market, they are probably as good as it gets at the liquid end of the spectrum. This is already a huge market in the US and it looks set to be the same in the UK with many quoted property companies converting to REITs. The question for any property investor in search of yield and liquidity is now “which REIT?”.

As with most investments, the less liquidity you are prepared to accept, the higher return you should expect. This is particularly so in commercial property where skill in working tenants, maximising planning and fine-tuning the finance takes time and makes a big difference to the total return. Many investors like to do this through syndication – the getting together of a number of “deep pockets” to buy a one-off property. This has been the way that most private banks have serviced their clients’ demand for high-return property investment – though there is often little in the way of diversification in this route and a lot of eggs can be sitting in one basket.

Probably the most sensible structure for those prepared to accept illiquidity is the “private equity” route. This typically means that investors commit themselves to providing capital over a long time period – often ten years or more – which will be drawn down as the deal-flow materialises. This neatly gets round the resentment that many investors feel when they subscribe to a new issue which raises a huge sum of cash which then sits around for years un-invested while generating fat fees for the management at the front end for raising the money – rather than for investment performance. In other words, there is often an unsatisfactory alignment of management and shareholders’ interests. In the case of the private equity approach, while nowhere near the same as for a single property, the entry levels here are traditionally high, almost certainly in six, and often seven, figures – if you can gain access. Like some clubs, entry is not easy (and has tended to be geared to the institutional rather than the private investor), and knowing where to go for the best management is advice that is difficult to find. The clear gap here is to offer investors low ticket-price access to funds that they would probably not know about and almost certainly would not be able to buy into on their own.

Geography is the last major issue the private investor needs to consider. If it is difficult for a UK based investor to buy a building on home territory, it is bravery indeed to contemplate a single building investment in say India or China. Unlike stock-markets which are very correlated (look at May and June this year), commercial property is much less so – a slump in commercial values in Houston, for instance, is not likely to be mirrored in Basingstoke. It is again worth noting that while UK pension funds have 53% of their equities in overseas markets, they have only 3% of their property exposure abroad. This is almost certain to change.

As a bank we have been looking at all these issues over the last few years and there seem to be some things that have relentless logic. The first is that investors, as part of a balanced portfolio, should have a significant proportion in commercial property both to provide income and/or give uncorrelated stability to a portfolio. The second is that, unless you are very rich indeed, you go down a collective route. Thirdly, if you go down the collective route, you need both advice as to what the best funds are and the clout behind you to get access to best management, which is as difficult to access as the best hedge funds. Lastly, you also need to think globally as the asset-allocation decision has a large geographical element to it – and if it is hard enough to alight on the best REIT in the UK, then you can be reasonably certain that finding the best private equity style fund in China or India is going to be a great deal more problematic – but probably a great deal more rewarding if you get it right.

* Source: Datastream Real Estate Index