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We have long held the view that the potential rewards from investing in commercial property funds are not worth the risk involved. Over the past 12 months, the challenges facing the commercial property sector have been heightened. Here, we revisit why we avoid this asset class.

What is commercial property?

Commercial properties are buildings that are used by businesses. They include spaces like offices, warehouses, retail parks, leisure buildings (like hotels or cinemas) and industrial buildings, such as manufacturing plants.

Property funds pool the money of investors together to invest directly in property, or in the shares of property companies. Investing in physical property comes with several risks; the main risk being ‘illiquidity’.

Illiquidity in investment terms means that it’s difficult to move or access your money without significantly impacting its price. This is because properties – much like the one you may own or live in – take a long time to be bought and sold, usually several months. They can’t be traded on traditional markets, like equities or bonds, which are generally referred to as ‘liquid’ as in most cases they can be traded on a daily basis.

What’s going on in the commercial property market?

The outlook for commercial property is gloomy to say the least. According to MSCI, October was the worst month on record for UK real estate.

The property market is closely linked to the wider economy and can therefore be significantly affected during times of downturn. Indications of a likely recession has resulted in a steep decline in property valuations and a slowdown in sales.

Rising interest rates have increased pressure on property owners and made investors more cautious. In common with residential property, as the cost of borrowing rises so do mortgage and lending rates making life difficult for owners and potential buyers. Demand for commercial property has slowed as the outlook for the UK economy has worsened.

Warehouses have had a particularly rough year as fewer businesses have wanted to expand their physical premises. However, the changing nature of our shopping habits with an ongoing shift towards e-commerce means that the sector stands to recover over the medium-term.

Hybrid working seems like it’s here to stay, leading to fall in demand for office space. This structural shift in demand is likely to have a long-lasting impact on the commercial property sector and may cause permanent scarring.

Bond yields (the rate of return you get for holding government or company debt) have risen in 2022 making this asset class more attractive for income-seeking investors. This is stern competition for commercial property funds, which also pay an income but are much less liquid.

What is Nutmeg’s view?

At Nutmeg, we do not own physical commercial property funds in our portfolios. For us, liquidity is paramount. We believe that the risk of illiquidity in property assets is high and could become problematic if the outlook for UK property gets even worse.

When investors become pessimistic about commercial property and want to withdraw their funds, they’re not always able to do so. As we saw in 2016 and 2020, some property funds were unable to sell or liquidate their holdings fast enough to meet investors’ demands for withdrawal. This meant they had to suspend redemptions, effectively locking investors in.

Liquidity is a risk often overlooked by investors, which is why we invest your money in highly liquid and transparent exchange traded funds (ETF) that are not subject to ‘gating’ or closures.

Our asset allocation process uses in-depth research from our investment team, and focuses on owning the right assets at the right time, and taking only an appropriate amount of risk for the portfolios we manage.

Too many investors have ignored the risks presented by commercial property in their search for higher returns but, in investing, history does have a nasty habit of repeating itself.

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.