Dive into pooled funds

The strategic case for allocating part of an investment portfolio to commercial property has been gathering momentum. Events in recent years, particularly the volatility and negative returns witnessed in other markets have resulted in a renewed focus on property as an investment. The typical arguments for making an allocation to commercial property within a multi-asset portfolio include:

• Low correlation with other asset classes.
• Comparatively low volatility of total returns.
• A secure income stream.
• Preservation of real values through income growth.
• A high relative income return.

For many private investors one of the most substantial assets they own is residential property, often in the form of their principal home. Does residential property act as a substitute for an allocation to commercial property?

In simple terms, past performance data show that multi-asset portfolios with an exposure to commercial and residential property would have been able to produce a higher level of return per unit of volatility than similar portfolios that ignored the potential benefits of investment in both forms of property allocation.

The beneficial impact of commercial and residential property within a mixed asset portfolio derives from the relatively low correlation of property with other non-property asset classes, and the fact that commercial property returns are not in line with those from residential property. The positive contribution to portfolio risk management of both commercial and residential is a logical consequence of the fact that the performance of commercial property is driven by factors different from those that influence residential property. This explains why the correlation between commercial and residential property, at less than 60 per cent, is not as high as one might expect.

If one looks at the return characteristics of the residential market solely within the context of wider property investment, the past returns that have been available for a given level of risk appear attractive. However, were one to build an optimal portfolio based on the risk/return characteristics of retail, office, industrial and residential property over the past 20 years, the resulting portfolio would be one made up of retail commercial property and residential property, which together have dominated each of the other sectors.

Residential and retail

At the main sector level, investment in either residential (high returns) or retail (low volatility) has provided a more attractive balance of risk and return than office and industrial investment, although there have been individual years in which offices or industrial property have provided the most attractive return.

The differences between the performance pattern provided by commercial and residential property exposure can be explained by looking at a range of criteria, relating to the overall strategic case for holding property in the first place. In this comparison, the assumption has been made that the residential property could be rented out (to the private rented sector), and as such the income characteristics are worthy of consideration.

Therefore, in terms of past performance and core characteristics, commercial property and residential property are significantly different types of investment. As such, investment in one should not preclude an allocation to the other. Until recently, for a non-tax-exempt investor who had decided to invest in property, the means of accessing investment performance in such a specialist market was problematic.

A highly efficient means of achieving an allocation to quality property is through investing in a pooled property fund, which offers diversification of property exposure, access to experienced property managers and greater flexibility and liquidity through owning units rather than property.

However, few pooled funds in which non-tax-exempt investors can invest have been made available.

The Schroder Indirect Real Estate Fund (SIRE) has been structured to allow private investors to buy units through their intermediary investment advisers. This is to create a portfolio of indirect property investments such as pooled property funds and property equities, that will provide a diversified property exposure to the UK property market, with an attractive return via income and capital appreciation.

Benefits of pooling:

• Allows investment in institutional grade property in each of the main property sectors, thereby providing diversification.
• Provides access to a range of appropriate indirect vehicles.
• Seeks to benefit from a performance kicker through the identification of mis-pricing between direct property and property equities.
• Many pooled funds benefit from a modest exposure to gearing through underlying funds.

John Hammond is head of strategy at Schroders Property