For many years, the received wisdom was that the bulk of private investors’ portfolios should be invested in equities – good old-fashioned stocks and shares – because, over time the total returns, i.e. in terms of capital growth and income, to be had from stock market investments were clearly superior to those obtainable from the obvious alternatives – cash, gilts, corporate bonds and property.

Add to that the illiquidity and cost of property investments, and the relative dearth of vehicles giving private investors easy access to the asset class, and you can understand why investors generally gave little thought towards allocating a proportion of their portfolios to property.

Attitudes, however, have changed significantly over the past decade. Increasing opportunities to make property-based investments have opened up, both directly and through various forms of collective investments. Specialist property managers have appeared offering bespoke portfolios to investors wanting a spread of direct property interests, whilst the number of funds, both open-ended and closed-ended, investing in the property sector has increased dramatically. Indeed, over the past two years, property funds have been the fastest growing sector of the investment trust market. At the same time, thousands of private investors have been putting together their own property portfolios, as evidenced by the explosion in the buy-to-let market

The reason why is easily explained by the chart on page 70. This shows the percentage total return over the past five years (to 31 August 2006) for the FTSE All Share index compared to three property sector indicators – the ABI Life Fund Property index, the seasonally adjusted Halifax Property index and the IPD All Property Monthly index. Over this period , the All Share has generated a pretty healthy looking total return of 36.6 per cent, especially when you consider that the first 20 months or so of the period were characterised by a steeply falling equity market, when the All Share fell by 30 per cent in less than a year.

Yet this pales into insignificance when compared to the returns posted by the ABI Property Fund index (68.3 per cent), the Halifax Property ndex (87.9 per cent) and the IPD index (97.5 per cent). And this outperformance was due to the fact that, whilst the stock market experienced a sharp fall followed by a strong recovery, property indices maintained a steady and largely unbroken upward trend.

However, the chart also underlines the two key questions facing any private investor considering exposure to the property market. Given the strength of the recent performance trends, can we continue to expect this level of outperformance in the future? And assuming that returns will remain attractive, which type of property investment should I choose?

Which type of investment?

To deal with the second question first, this is the most important aspect of the property sector for private investors to grasp, as it is not a single sector. There are three main elements, represented by the three different property indices in the graph – commercial property, residential property and property shares – and these can behave very differently from each other at different times.

To take the different indices individually, the ABI Property Life Fund index represents those property-based funds run by life assurance companies and linked to their assurance-based products, investment bonds and the like. As they are generally invested in a mix of directly held properties (usually commercial) and the shares of property-based companies, you would expect them to outperform the stock market when property returns are strong, but not by as much as the ‘pure’ property indices, because of the ‘drag effect’ of the share portfolio.

This is something else that investors can be slow to realise. One of the attractions of the property market is that it is not correlated with the equity market. This means that property prices and yields don’t move in line with share prices and yields and makes property an attractive alternative for investors who feel they have too much committed to the stock market already and want to diversify their risk into other areas.

However, such diversification is only achieved if you buy into property directly – you acquire real bricks and mortar. Whilst investing in the shares of property companies will give you some exposure to the underlying asset it won’t remove the correlation with the stock market because the shares of property companies are part of the stock market. This is why specialists in the sector say that if you want to invest in property, you should buy property, since property shares still behave like shares.

Next: Residential vs Commercial