Property funds and bonds explained.
We look into property funds and bonds to show investors the benefits and pitfalls of investing indirectly through collective investment schemes.
This article is split into two parts. In the first part, we analyse property funds. We explain to you what they are, and how they work. We will give an overview of their advantages and disadvantages for this large sector of the financial markets.
In the second part, we will review property bonds. At this point, we will explain what they are, and how they work. We will show you the pros and cons of this asset class, as well as give you the low down on key terminology. Hopefully, by the end of the second part, you will be better placed to know whether either funds or bonds are suitable for your investment needs.
Part 1- Property Funds
Some people like to invest in property via funds, as it gives them exposure to property investment without having to buy the physical asset. Let’s take a look at the key information.
What is a property fund?
Quite simply, a fund is a collective investment scheme. When you invest in a property fund, you purchase units in an investment which is managed by a professional investment manager. They pool your money with other investors in the fund. The fund then invests in property.
How do property funds work?
Depending on the rules of the fund, you can invest in residential, commercial, or industrial assets. Each property fund will have rules placed on the investment manager, determining how they can manage your and other investors’ money.
A certain fund may have stipulations that it has to keep a certain percentage in cash, and different portions in residential, commercial and industrial property. Alternatively, the fund may exclusively be invested in commercial property.
The fund can also decide on the types of companies which qualify for investment in the fund. This could be a minimum size by, market capitalisation or assets under management, or the credit rating of each company it invests into. Alternatively, the fund may invest into assets directly, therefore not investing in any companies which are listed on the stock exchange. All of these decisions will be governed by the rules of the fund.
Due to the complexity of funds, they are considered to be an approved product for regulation by the Financial Conduct Authority. This is to ensure that anyone administering advice is both authorised and qualified to do so.
You can invest in a range of funds. But not just only in the way they invest but also in their structure. The most common classifications are open-ended and close-ended.
Close ended funds
Close-ended funds are typically investment trusts. There is a fixed amount of shares in circulation. You can only buy shares when someone sells their holdings. Conversely, you can only sell when someone buys from you. This is usually conducted from an exchange. This difference between the buy and sell price is the spread. Because you need to find a buyer to sell, close-ended funds can be more volatile than their open-ended counterparts.
Open ended funds
Open-ended funds by contrast, don’t have a fixed number of units. If you want to buy units the fund simply creates more and the circulation increases. Similarly when you sell the fund gets smaller. This is the structure for unit trusts and OEICs. The advantage of being open-ended is there is more liquidity and a little less volatility compared to their closed-end counterparts. On the negative side, this means the fund manager always needs to keep a certain amount in cash to cater to this variance in units.
Advantages of property funds
There are some advantages of investing in funds. We list the main benefits below.
- Convenience. Let’s face it, buying property can be hard work. You have to source the property, put in an offer, then go through the conveyancing process. This involves instructing a solicitor. Going through exchange of contracts then completion. Then you need to find and source tenants. Maybe even renovate the property. All of this costs time and money. When buying through a fund you don’t have to deal with any of this. You simply find the fund which best suits your investment requirements.
- Less red tape. There are a lot more legalities to deal with when buying property direct. Especially when dealing with commercial property. Failure to follow the rules can result in hefty fines.
- Professionally managed. With funds, you are entrusting an expert to oversee the investment. They have the expertise and resources to do the necessary due diligence. Furthermore, with larger amounts of funds under management they can diversify risk, and negotiate bigger discounts on the buy side.
- Ease of access. Buying property is a major decision as it is of a substantial cost to the average investor. Commercial property may be out of reach for many investors, due to high entry levels. With many funds, you can invest as little as you like.
- Liquidity. Property can very illiquid. Especially commercial property which requires a lot more research by prospective buyers. Funds offer far more liquidity. However, the caveat is that certain funds can prevent investors exiting under exceptional circumstances.
Disadvantages of property funds
Property funds have their disadvantages too. Below we enclose some of the biggest issues.
Other investors. When you own a property you can decide on what terms you wish to sell. When you are involved in a fund you do not have this luxury. If many investors want to exit, the fund manager may be forced to sell an asset below market value to provide liquidity. This is to the detriment of existing shareholders.
Management charges. When investing in a fund, you have several people on the payroll. The fund manager, your IFA and other professionals all need remunerating and this comes from management fees.
Ridged structure. Whilst fund structures are put in place for investor protection, they can sometimes work against the fund manager. They may not be able to hold onto a good asset because the fund needs to rebalance to meet its structure rules. This means fund managers can’t deliver the best absolute returns.
Double taxation. Many funds are charged corporation tax on their profits. As an investor you are then charged on the income you receive in the form of dividends, and when you go to sell you may have capital gains to pay as well. This makes buying a property directly more tax efficient. However, there is one exception, and this is Real Estate Investment Trusts (REITs).
Illiquidity. In exceptional circumstances funds can be suspended due to financial problems in the wider economy. This happened during COVID in 2020. For investors that needed the funds, this forced them to sell other assets.
REITs offer exceptional tax advantages as they are exempt from corporation tax. This means returns are paid to you gross. Because of their favourable structure, they have grown very quickly as an asset class, since they we introduced 15 years ago. You can find out more about the advantages of REITs here.
Should I invest in property funds?
As you can see there are several advantages to investing in property funds, especially tax-efficient ones such as REITs. The lower entry levels, increased diversification and liquidity are attractive benefits, as is the convenience of not buying property direct.
However, for investors who want convenience, whilst still having direct ownership, there are other options. Purpose built student accommodation can offer a high yield, passive investment, with a modest entry level. This is what investors in property funds are usually seeking. Another alternative to property funds is to look at property bonds. We explain the pros and cons of property bonds in the next part of the article. Progress to part 2.