Build up your property portfolio brick by brick

If buying buildings still feels too risky as a direct investment, funds could be the way to go. Alessia Horwich reports

(OLI SCARFF / GETTY IMAGES)

The signs emanating from the UK property market are still mixed. In June, house prices rose according to Nationwide but fell by the estimates of the Halifax. Yet, overall, many market watchers reckon that the unrelenting downward move in house prices we have seen since late 2007 may now have come to an end.

But making money from buying property at or near the bottom of the property slump is difficult. There is a deposit to find and a mortgage to get once you've found a property, to say nothing of potential negative equity.

An alternative to direct investment in bricks and mortar are property funds. Investment in property funds is a larger-scale version of buying property in that you invest your capital into a fund, which either buys property directly or invests your money in the shares of a company which buys property. If the fund is invested directly, the rental income will provide an annual yield to you as the investor. Then, when you wish to withdraw your investment, you will receive the initial sum plus any capital growth on the value of the property itself. Where the fund is used to buy stock, the return will be in the form of dividends and, should you come to sell, the growth in share price.

Before the recent market crash, property funds were big business and boasted supposed solid low-risk returns. However, the overheated market led to a false sense of security and when property prices tumbled, losses were massive. Despite doubts about the property bubble bursting, investors continued to throw cash at the market as previous returns had been so good. "A lot of the advice is based on past performance; it's like a rear-view mirror," says Bruce Bulgin, partner at financial advisers Chadney Bulgin LLP. "Providers hyped up investment massively based on double-digit returns from past years, but they may well have been paying too much when the economy went into recession."

Most losses were made by those invested in commercial properties such as shops, offices and factories. These were seen as preferable to residential as a low-maintenance investment, yet yields were similar to those of low-risk corporate bonds. "The advantage of commercial property," says Colin Jackson, director of financial advisers Baronworth, "is that you have a long lease [usually 25 years] and regular rent reviews that nowadays are upward only. Tenants go in with a full repairing covenant so they are responsible for repairs and maintenance."

It may be low maintenance but many who pumped cash into commercial funds pre-recession have seen their tenants' businesses go bust and take the rental income with them. And poor liquidity prevented investors from withdrawing their capital: funds held the majority of the capital in equities and simply did not have the cash. So either investors could not withdraw their money, or properties were sold at a loss to release capital. It was the investors that took the hit.

As a result of these big losses, many are still very wary of property. "We're building up our property exposure carefully," says Adrian Lowcock, senior investment adviser at Best Invest. "There may still be falls and hiccups in the market, but for the moment there is a good balance between yields and risk." Others, however, are powering into the market and instead of commercial property, they are turning their hand to residential investment. Stephen Yorke, chairman of D&G Investment Management says, "Not all residential property funds are a good idea. The key to making money in property is to be highly selective about where you put your money."

His £10m Prime London Capital Fund, which has between 90 and 100 investors, holds properties solely in prime London locations, such as Chelsea, Knightsbridge and South Kensington, as designated by property broker Savills. These areas, he says, are not subject to the normal movements of the market and are always desirable, so there are big profits to be made. "In Prime London, when you have economic weakness, the rich take their property off the market. As a result you get stock shortages and drying up of transactions. Then when demand returns there is a supply squeeze and prices start to rise rapidly."

According to the company's statistics, during the recession in the early 1990s, Prime London property prices fell 30 per cent in value, only to rise the same amount over the following two years. "It feels very similar right now," says Mr Yorke. "I think the Prime London property market bottomed in January. Since then prices have been rising, initially quite modestly, but it's starting to pick up."

The minimum buy-in to the fund is £1,000 and the current annual yield across the portfolio is above 5 per cent. This kind of fund gives those with little cash to put down access to properties they would otherwise not be able to touch, but getting into the fund will cost you. Fees up front run between 2 and 5 per cent, but if you invest large amounts this charge is negotiable. There is then an annual management fee of 1.75 per cent and, as the fund deals with non-repairing leases, investors will have to absorb the property management costs, which run to 13 per cent of annual rental income.

Another issue is that homeowners already have a vested interest in residential property. "If you own your own home why do you want more exposure to the residential property market?" Asks Mr Lowcock. "You're better off diversifying into commercial property or bonds."

But homeowner or not, is now the right time to be investing in any property? "No property investment at the moment is a good idea," says Ben Yearsley, investment manager at Hargreaves Lansdown. "Commercial property is still falling and commercial funds only move around 1 or 2 per cent a month. You can afford to wait for the funds to pick up before making an investment. There's no point in rushing."