The horror-story headlines splashed across the newspapers at the moment regarding the property market are enough to alarm anyone. Especially as, in recent years, investors have been increasingly attracted to commercial property as an asset for its relative stability and the income it provides.

Fund managers were barred from openly marketing commercial investment funds until around three and a half years ago, says Don Jordison, managing director of Threadneedle Property Investments.

Suddenly, fund houses started to develop far more interesting and accessible products in parallel with the leap in general interest in UK property, says Jordison. ‘Then, about two years ago, when property became an investment you could put into an ISA, things really changed for this market.’

Investor sentiment
Understandably, the residential housing boom raised investors’ expectations of the market, adding an expectation of capital gain to the traditional income attractions. But the fact is that performance has fallen away, and investors in both the residential and commercial property markets are right to be concerned.

UK property stocks briefly rallied in January this year and shares rose by 16 per cent in three weeks, but this was short lived.  Figures from Reita, a group that campaigns to encourage property investment, showed UK property stocks subsequently fell further, and the Reita panel, constituting 24 property investment firms, projects property holdings dropping by ten per cent this year. Few expect the UK commercial property market to recover until next year.

Commercial property vehicles
Commercial property constitutes anything from hotels to office blocks, shopping centres to commercial forestry projects.

Most investors access it through property trusts or funds offered by high street names like Norwich Union, New Star, Threadneedle and Scottish Widows.

These funds largely invest in prime assets such as city-centre office blocks and have relatively passive management strategies, says Robert Walters, property investment director at BDO Stoy Hayward. To allow investors access to their money, all funds keep five to ten per cent of the fund in cash or other liquid instruments.

But the lack of liquidity in these funds caused problems last year. Fund providers, including Friends Provident, AXA and Scottish Widows, imposed six-month redemption notice periods on investors as the credit crunch hit, which effectively barred investors from access to their cash as prices tumbled further. Instead of waiting the problems out, plenty of investors panicked and fund managers were forced to sell properties for cash.

Figures from the Investment Management Association (IMA) suggest investors withdrew £77 million from property funds in January alone.

A range of options
Walters says, ‘The key to selecting from these funds is to seek advice from an independent financial adviser who can get you access to institutional funds that invest solely in properties themselves for fixed periods of investment.’ Institutional funds tend to offer far higher barriers to entry of £25,000 to £50,000, compared to retail average entry levels of £5,000.

Walters adds, ‘Equally, you can take advantage of the current market confusion with a retail fund, but make sure you take specialist advice at some point, and make sure your fund manager is a good stockpicker.’

There are also unauthorised property funds, which are unregulated by the FSA, and largely for this reason Jordison says he wouldn’t recommend them to the average investor. Considering the liquidity issues many funds are experiencing, these are a risky option because unauthorised funds can place 100 per cent of the fund’s assets into bricks and mortar.

If you have a self-invested personal pension (SIPP), which allows you to invest your own pension pot instead of handing it over to a pension provider, you can include most property investments in this – commercial property, property shares, property funds and real estate investment trusts (REITs). However, buy-to-let investments were disallowed by the government when it realised the enormous tax advantages that this offered landlords.

Like all pensions, this means that when a basic 20 per cent rate taxpayer invests £100, it only costs £80 because the government rebates the tax. Investors can contribute 100 per cent of annual earnings before tax up to a limit of £235,000 for the 2007/08 tax year. This will increase by £10,000 a year until 2010/11.

Getting the right vehicle
REITs offer another route into commercial property, but these have fared little better in the current climate. Launched in the UK in January 2007, REITs are listed companies quoted on the stock exchange that own and manage income-producing property.

The trusts offer tax advantages as they do not pay corporation tax, but tend to be highly geared and so relatively volatile investments in a straight comparison with traditional property investment trusts. Investors get a double hit of risk because they are exposed both to the value of the commercial property the Reit owns and to the listed share price of the Reit.

Commercial property can also be slipped into a structure to mitigate inheritance tax (IHT) liability using business property relief, and Close Investments is currently offering two-year plans called Close Trading Companies (CTCs). The sum invested is protected, although not guaranteed; investors become sole shareholders in the trading company’s activities in commercial property, managed public houses or commercial forestry. The plan qualifies for 100 per cent business property relief.

Robert Meyer, assistant director for specialist sales at Close Investments, explains that ‘Business property relief has been around for a long time. Typically, it was enlisted to shield family businesses so they didn’t get crippled by estates tax.’ He adds that over 1,600 companies have been set up for ‘relatively high net worth individuals’, and as long as clients survive the two years from set-up, the funds remain exempt from IHT.

Commercial decisions
Limited partnerships offer another route into commercial property. Favoured by law firms and other professional practices as a way to buy into their own office building, limited partnership companies are also enlisted to structure closed-ended property funds. Again, investors benefit from the tax efficiency of the limited company structure but must complete a tax return on the company at the end of each year.

But Robert Walters suggests, ‘The critical issue is not the structure of the limited partnership, SIPP or any other vehicle, but the quality of the property and the property manager. The crucial question is: does the fund manager have a track record of adding value?

‘In a downturn, a skilled fund manager can exploit inefficiencies and distressed sales to increase performance, and commercial property shares are currently priced at a massive discount to the value of their underlying assets.’

But Walters adds that the real danger for property is if the UK enters recession: ‘If the UK holds up, the commercial property opportunities remain, but if it enters recession, all bets are off.’