Funds: steer clear of commercial property

All too often, last year's most popular sector turns out to be the one that delivers the worst returns this year.

So given that commercial property has been among the top investment fund sectors for retail investors for several years now, having returned in the region of 18% a year since 2004, it's not done too badly. Retail investors pumped £5bn into the sector in the 18 months to July.

But now the winning streak is well and truly over. Earlier this week, fund manager New Star reported that the value of its UK Property unit trust has now fallen by 18% in less than six months.

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It's far from being the only one with problems. Aviva's £3.7bn Norwich Property Trust says Patrick Hosking in The Times, is "plagued by rumours that it is in talks with the Financial Services Authority to get trading suspended" in the trust.

The credit crunch', as ever, is being blamed for the problem. And certainly, now that banks are scared to lend each other, it's understandably become difficult for anyone to raise the funds needed to buy and therefore sell commercial property.

Beware! Popular funds are often not the best investments

But the warning signs were there well before August. Just as with buy-to-let investments, rising interest rates had pushed the cost of borrowing above the rental yields on commercial property. When debt servicing costs rise above your income stream from an asset, it doesn't make sense for most people to buy it anymore. So the sector was primed for a fall, even as fund managers were diving headlong into the sector with new funds aimed squarely at the small investor.

It's not too different from all the tech funds that were launched in 2000, just as the dot-com bubble was about to blow up. Let's be clear here, this is not a coincidence. Fund managers make their money from the fees that investors pay them to manage their assets. The more assets they attract, the more fees they make.

When an asset class like tech stocks, or commercial property is booming, it attracts a lot of attention. So when small investors line up to work out where to put their money that year, the most successful sector tends to be uppermost in their minds. "Commercial property up 18%? You can't go wrong with bricks and mortar I'll have some of that."

When that investor goes on the internet and types in commercial property funds', the average fund management group wants its name to come up at the top of the list. So the decision to launch a fund is driven at least as much by a sector's popularity with retail investors, as by its actual prospects of making any money.

But of course, the longer a sector has outperformed, the more likely it is to drop off its perch. So by the time fund managers are piling in with new launches, it's usually getting into the last days of a boom hence the frequent plunge in performance just as the majority of investors are getting into a sector.

In any case, given the sector's popularity with retail investors, there's a strong chance that you might hold some commercial property in your portfolio. So what should you do with it now?

What to do with your property funds now

The big problem with property funds is that it's hard to sell the underlying asset, but it's meant to be easy to sell the fund itself. So property funds have a cushion of cash and property shares that they can use to give investors their money back if outflows exceed inflows.

But now that everyone is evacuating the sector, those cushions are becoming somewhat threadbare. The big worry is that if this carries on, one of the funds may have to stop retail investors from withdrawing money; some have already stopped institutional investors from doing so. And once that happens, the others will more than likely see a run on their holdings.

That's partly the reason why New Star has now decided to revalue its fund every fortnight rather than every month the faster that prices fall, the more likely that investors will leave their money with the fund, in the hope that it will eventually recover. Not to mention the fact that any withdrawals will be paid at lower rates.

Most pundits are still claiming that the market will recover in 2008 at some point but with the UK economy just starting to turn down, things could get much nastier than anyone is admitting. If over-indebted consumers stop spending, then retailers will suffer, meaning job losses and slower demand for high street property. And the credit crunch is already hitting jobs in the City how much longer before it starts to hurt demand for offices too?

I'd be inclined to sell out now and take any losses on the chin before things get worse. If you do decide to stick with it, just make sure that you don't need to get at any money you have tied up in the sector in a hurry.