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Many happy returns

by: By Charles Ansdell, senior technical adviser at Inter Alliance
  • 08/09/2003
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Many investors have had their fingers burnt over the last few years, but some areas of property investment have proved consistently strong in a weak market

It has been a torrid time for investors over the last few years. Plunging equity markets have shaken confidence and vastly exacerbated the pensions gap. Investment-grade corporate bonds and gilts have been over-bought and are therefore overpriced. And money market funds, given current inflation levels, are unlikely to offer positive real returns.

However, among this mayhem, property has shone as an investment vehicle and stellar capital returns on houses have driven investors into property. This has lead to heavy investment in those property funds that invest in commercial or residential property. Equally, more obtuse property funds, such as those investing in real estate and student accommodation, have also been heavily sought.

To date the most popular investment has been the residential buy-to-let, where low interest rates and stable rents have created a source of both income and capital aggregation for investors. Here property has truly looked attractive. Indeed, it is ironic that property and gold, championed by the discredited 17-18th century physiocrat and bullionist economists, have also been the best performing investments recently.

Uncertain future

Nevertheless, cracks have started to show recently. Fears that residential prices are over-inflated have been reflected in falling house values in the South East. Furthermore, over-saturation of buy to let in some areas has led to a gradual fall in rental values; meaning that buy-to-let rental income may not cover mortgage payments. This has led to people selling buy to lets – further depressing retail property prices.

The commercial market also faces uncertainty due to the general economic environment. Commercial funds have radically improved their research and reduced risks through investing in property with long leaseholds, and having index linked rents. However, the mid-90s spectre of empty Canary Wharf offices remains, and investors should be cautious given that the finance sector, which fuels much commercial property demand, is still in downturn. Although signs of recovery look imminent, it may be sometime before the banks are recruiting significantly, and fuelling the demand for greater office space.

With property uncertain, equities unpopular and corporate bonds overvalued, investors may be forgiven for thinking their money might best be stored under the mattress. However, property still offers strong yield opportunities. Despite the uncertainty creeping into the retail property market, there are alternative property-based investments that are well worth looking at.

Ground rent funds work by buying the freeholds of buildings and then taking income from the ground rent of the property leaseholders. Usually, the leaseholders are long-term and the ground rents index linked, thereby providing the fund with a relatively secure source of income. Additionally, the funds can increase ground rents whenever leases expire or are extended.

On top of this, ground rent funds can further increase returns through the sale of lease extensions or the sale of freeholds. This combination of cash flow and capital accumulation can provide a potent combination, which has been reflected in these funds’ strong performance.

Ground rents are traded in blocks and usually bought at regular auctions held throughout the UK and privately through specialist agents.

There are four ground rent funds currently available, although there are industry murmurs about more launching. The lack of correlation between ground rents and equity volatility means that returns have remained strong in spite of equity difficulties, and should remain to do so.

Both Irish Life and Royal Sun Alliance funds are managed by The Brandeaux Group, a British Virgin Islands based fund management company. All the funds are classified as unauthorised offshore investments and, as such, do not offer the investor the degree of protection of an onshore Financial Services Authority-regulated fund.

Generally, the highest regarded is the Freehold Income Trust, run by Antony Wyld. Launched in 1994, and the longest running fund, it has delivered consistently strong returns. This offers income units or accumulation units (where the income is reinvested) or a combination of both. Income units pay twice yearly, and this is paid gross to investors (they are responsible for any income tax liability). Accumulation units are treated the same for tax purposes.

The key investment decision making of Freehold Income Trust is undertaken by Freehold Managers plc. It is also responsible for property management decisions, and its fee is related to the performance of these decisions. It is also responsible for the rent collection and administration of the investments.

Ground rent funds are clearly constrained by the number of properties that are viable investments. Therefore most remain small and nimble to retain their investment flexibility. Recently, Royal Sun Alliance stopped receiving funds into its Ground Rent Income Fund – Series 2, in order to ensure returns (this is a medium term measure). The size of fund is therefore an important investment consideration, as well as the availability of freehold options.

Threats and opportunities

However, the major threat to ground rent funds comes from property legislation, through the anticipated negative implications from The Commonhold and Leasehold Reform Bill, which came into law in July 2003. But this has so far failed to materialise. This gave leaseholders new powers in managing properties, including improving the ability to obtain longer leases, and requiring landlords to give written notice to leaseholders before imposing changes to ground rent.

Nevertheless, ground rent funds look a less risky alternative to conventional property funds since income from ground rents is not linked to property prices. That said, really strong fund performance is likely to be driven by extending leases or selling freeholds, which is linked to property prices.

Another type of collective investment is Property Syndicates. These are formed to facilitate private investment in commercial properties with a purchase price of between £2m and £60m. These range from company group head offices to sports and retail complexes. Open to individuals (pension funds including SIPPs and SSASs cannot use them), syndicates are generally formed before the property is built.

Key to the success of any syndicate is the quality of tenant and the agreed terms of the lease. This will usually be for 25-35 years with pre-agreed initial costs and future increases, so good tenants with good track records are vital. The future value of the property will depend on its location, tenant and minimum future rental income, all of which are known. Therefore, the future value can be fairly accurately calculated so that individuals’ gains within the syndicate can be estimated for a given time in the future.

A property syndicate can provide investors with good levels of return with lower levels of risk. The downside is there is no means to sell member’s holdings outside normal exit points, and money is locked in. This reduced access and other risk factors mean that potential investors should be advised seek full professional advice from a solicitor before investing in syndicates. Indeed, syndicates are legally structured by solicitors so it is always best to put an investor in touch the relevant solicitor.

Equally, it should be considered that, unlike unit trusts, these are closed investments and therefore the number of high quality opportunities is extremely limited. It should also be considered syndicates are not without risk – the importance of tenants locked into long term, index linked contracts is essential. Nevertheless, syndicates are distinctly less risky than directly investing in property and the associated risks those carry.

Although the property market is not likely to prove the ultimate investment nirvana, it has remained the asset class of choice over recent times. Indeed, Thatcher’s initiatives in the late 1980s to promote private home ownership have pushed a large proportion of the UK’s wealth into property, a situation unique to the UK.

And with this in mind, long term capital growth investments such as property syndicates look distinctly attractive. And the option of investing in pooled funds, such as ground rent funds for income and medium term capital growth remain a viable option.

No other asset class can offer the same level of returns achievable from a low risk, stable investment. And while equity markets remain highly volatile, and fixed interest investments look overvalued, investors may well be able to find more solid foundations in property.

Investment syndicate case study

In 2002 Claymoss Properties arranged a syndicate to buy a property at Barracks Road in Newcastle-under-Lyme where members’ minimum investment was £22,500. However, this was ‘geared’ by a bank loan of £68,500 giving a total investment of £91,000. This was a non-recourse loan, was non-status based and no disclosure of individual circumstances was required.

This investment bought the member a ‘slice’ of the property. During the term of investment income from the property pays interest on the loan (fixed at 1.35% over the costs of funds for this syndicate), with any surplus used to reduce borrowings. Members receive no income during this period, but there are specific exit points where the investment can be sold. These specific exit points provide the minimum investment term, since few investors want to commit themselves to a 35-year term. However, the tax implications need to be examined before any decision is made.

The value at these exit points is largely known, although there could be fluctuations in variables such as interest on the borrowings. For Barracks Road, projected exit yields at ten years vary from 298% to 387% of the member’s original investment, equating to a compound return of 11.05% to 14.4% per annum.

At twenty years figures are augmented by rental income, as borrowings should be fully repaid during year sixteen. Approximately 184% of the members’ equity should be initially available from the accrued income between 2019 and 2022. This alone gives a compound return of 3.1% per annum.

The sale price at this point (based on 3% inflation) is projected to give a further 730% of members’ original equity, a 10.4% return per annum. The total projected return equates to a very reasonable 13.5% per annum over twenty years.

key points

Buy to let and commercial funds have proved successful, but falling prices and rental income in some areas is of growing concern.

Collective ground rent funds give investors long-term income through ground rents, lease extensions and sale of freeholds.

Property syndicates buy into commercial properties and offer long-term stability in return for long term commitment.


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