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BLOG: Is property the answer to the income conundrum?

Darius McDermott
Written By:
Darius McDermott

Darius McDermott of Chelsea Financial Services explains why property funds could be the solution for beleaguered income seekers.

When Ben Bernanke let the ‘tapering genie’ out of the bag on 22nd May he reminded us all that markets and economies will, at some point, have to function independently once again, without the help of money printing from central banks. He also reminded us that interest rates have only one way to go.

His comments, some of which have been tempered since, led to falls in most asset classes and talk of a bond bubble about to burst.

Quantitative easing is the biggest financial experiment of our lifetime and bond investors have obviously taken Bernanke’s comments as a signal to sell – not all their holdings but certainly some – as they look to rebalance their portfolios and make sure they are diversified enough to cope with whatever lies ahead.

According to the Investment Management Association, which records the flows of money in and out of investment funds, June saw outflows of more than £620m from bond funds, the largest amount since records began in 1992. Having been the best seller just 12 months ago, corporate bond funds in particular have suffered a fall from grace and were the least popular in terms of sales last month.

With interest rates still at record lows, however, the worries over bonds leave income investors in a bit of a quandary. With a lot of money already in equity income funds, as the search for income has led many to take on more risk, how can they diversify their income streams?

One option, I think, lies in property funds. Returns from real estate are closely correlated with GDP growth (the health of the economy). So it’s no surprise that returns from the sector have been muted since the great recession of 2008-2009. But for long-term investors, with a diversified portfolio, I think the outlook has improved enough to make the asset class attractive once again.

While asset prices, with the exception of ‘shiny London hot spots’ as one manager put it, have been flat or falling for most of the past five years, the income element has held up well. The property market now appears to be stabilising. Capital flows are increasing and more positive economic fundamentals mean business and occupier confidence is growing, as well as improving investor confidence in the asset class. These factors should also further underpin the income stream.

The majority of bricks and mortar commercial property funds yield 3% or more (comparable with most corporate bond funds today) and while the income on buy-to-let may be higher, I believe the former make more sense for most investors as the hassle is taken away and you can invest in more than one property, gaining valuable diversification. And in the UK, so many of us have our greatest investment in our own home, I don’t really see the point in putting even more in residential property.

This income could receive a further boost in the not too distant future as property funds convert to a new structure: Property Authorised Investment Funds or PAIFs. Keeping things simple, a PAIF is a tax-free fund, investing primarily in property and is described as open ended (there is no limit on the number of shares issued).

It’s the tax-free part which is important for income seekers, as it means ISA, Junior ISA and pension investors will no longer incur the 20% tax, which would previously have been applied on income received from the property investment. This means the income earned will get an immediate boost. For example, a property fund with an historic yield of around 3% last year would see that yield increase to around 4% if it converted to a PAIF.

Investors do need to be aware that this asset class can be illiquid though – we all know it can take many months to sell a house – and funds have a history of having to suspend trading if there are more people wanting to redeem than buy. While suspending a fund like this is in the interest of underlying investors (so properties don’t have to be sold at a discount to meet redemptions) that is often little consolation to people who want their cash.

But for income investors looking to diversify their income stream further or find an alternative for some of their fixed income holdings, I think the sector is definitely worth a look.

Darius McDermott is managing director of Chelsea Financial Services