Once seen as an effective hedge against inflation, commercial property funds are now losing money and are hard to cash in, writes Fiona Reddan

THEY WERE touted as the ideal investment during the Celtic Tiger years. Investors, who may have already bought heavily into residential property by buying holiday homes and properties for rent, were also able to get exposure to commercial property by investing in any number of funds which appeared on the Irish market.

Unlike property syndicates, which were aimed firmly at the high net worth individual, commercial property funds were open to the average retail investor, with minimum investments starting at about €10,000.

Seen as an effective hedge against inflation, commercial property funds were actually the best-performing asset class of the Celtic Tiger years, outperforming even Irish equities.

Now, however, with the property bubble having finally burst, investors are stuck with an investment which is rapidly falling in value and is very difficult to cash in.

So far, a number of the major providers of property funds in Ireland have imposed a six-month ban on cash redemptions as they struggle to keep their funds liquid.

Friends First introduced a six-month deferral on all instructions to withdraw funds from its Irish commercial property fund on September 29th, and says that it has "no plans to withdraw this deferral in the immediate future", while investors in Hibernian's European Residential Property Fund also have to endure a six-month notice period before they can cash in their holdings in the fund.

The suspensions have been necessary to prevent a "fire sale" of properties, whereby the fund managers sell off a number of properties regardless of the prices received in order to raise cash.

Normally, property funds keep a buffer of about 10 to 15 per cent of assets in cash to meet the demand for withdrawals. However, as the credit crunch kicked in late last year and the property market began to stagnate, investors moved to cash in their gains, thereby causing the buffers at many funds to drop.

Last March, Friends First had an allocation of 11.1 per cent to cash, but by the end of September, the cash content of its fund had turned to a negative, at -4.7 per cent.

In addition to encashments, according to the firm, the cash allocation proportion of the fund also contracted due to accrual expenditure associated with a particular development. However, Friends First expects "rental income to rebalance this going forward".

Nevertheless, fire sales may be on the way. In September, Irish Life braved the market when it put a €70 million office portfolio, including Hambleden House, the head office of property agent Bannon Commercial and Colliers Jackson-Stops, up for sale as an off-the-market transaction. The properties have yet to sell.

Industry experts say that there are many other properties which have been placed discreetly on the market. Eamon Porter, a principal with Aspire Wealth Management, predicts that more fund managers will look to offload properties in the hope of raising cash to meet redemptions.

But what should you do if you have invested in a property fund? Try and get what's left of your money out now or sit it out?

While some investors, particularly those who are self-employed and are under pressure to raise funds for their own businesses, may need to request an encashment, Porter would only suggest "with a lot of reluctance" that they look to cash in their investment, as he expects funds will lose about 40 per cent of their value from peak to trough.

So far, Irish commercial property funds are down about a quarter in the first nine months of this year, with a dramatic decline of over 15 per cent reported in the third quarter, according to statistics from Mercer Investment Consulting, although this is still an improvement on Irish equity funds, which fell by 31 per cent during the same period.

In the year to date, Canada Life/Setanta's funds were the worst performing, falling off by 33.8 per cent, while AIB Investment Managers managed to keep its losses down to 16 per cent.

Such poor performances have dragged the three-year average of many funds into the red, with New Ireland and Hibernian now reporting negative returns over the past three years.

But property funds are difficult to value, particularly in the current environment which is characterised by a sheer lack of transactions, so the real decline in these funds may actually be greater.

In the first nine months of 2008, just €465 million of transactions were conducted in the Irish market, down from €1.6 billion during the same period in 2007.

Despite the reduction of commercial property stamp duty in the Budget from 9 per cent to 6 per cent, it is unlikely that the market will pick up any time soon.

Investors remain fearful and banks are reluctant to lend further, given their already significant exposures to the property market, so in the short-term, capital values are likely to decline further.

As consumer sentiment declines, leading to a fall-off in spending, the retail market can be expected to suffer further. Although Dundrum Shopping Centre has just undergone a major expansion, it is likely that retail developments around the State will be halted or postponed until conditions improve.

In the commercial sector, office vacancy levels continue to rise, and there is an estimated €1 billion of investment stock left on the market.

Patrick Koucheravy, a property economist with CB Richard Ellis, says the short-term outlook is very challenging.

"There is a stand-off between sellers, who are reluctant to lower prices, and buyers, who might be in a position to purchase but who are looking for maximum value," he says, adding that in the absence of transactions, it is not possible to accurately say how far prices have fallen, with values driven by sentiment rather than hard evidence.

Until the market does pick up, and a major transaction enables analysts to call the bottom of the market, it will remain very difficult to assess the true value of Irish property funds.

Earlier this month, Friends First revalued its Corinthian Property Fund, which owns three Superquinn supermarket sites among its investments.

The new valuation means the fund has now fallen in value by 46 per cent. This may not be an altogether accurate indicator, however, as this fund was only established in 2007 and set-up costs will have been factored into its decline.

Those investors who are keen to cash in their investments should also be aware that, while they may give their request to exit the fund now, dependent on the fund, the requests will only be processed at the end of the deferral period at the then unit price of the fund, ie the unit price after the six months' deferral, not the unit price at the time the instruction was given. As a result, they will be taking a gamble on where the price will go.

Moreover, investors may have to stump up an encashment penalty for early withdrawals. Typically, this figure is about 5 per cent, depending on how long the investment had been held.

Another aspect of the current environment is the re-pricing of commercial property funds. For example, Standard Life has no redemption policy on its UK commercial property fund which it offers to Irish investors, but like other funds, it has changed its pricing basis from a maximum to a minimum valuation basis, which means that the unit price is lowered by 6.7 per cent on exit.

Similarly, last December Hibernian changed the pricing on its funds from a disposal basis, as opposed to an acquisition basis, due to cash flow into the fund turning from positive to negative, ie more money going out than coming in.

This is a common strategy adopted by property fund managers and is used to contain losses.

When a fund is growing, units in the fund are priced at a maximum value, which includes the cost of purchasing the underlying asset, such as stamp duty.

However, when a fund is contracting and is selling assets, units are generally priced on a minimum valuation basis, which takes account of the cost of selling the underlying assets.

But it is not all doom and gloom. Investors who got into property funds as a long-term investment and as part of a balanced portfolio, and who don't have an urgent need for cash, should be able to hold tight and wait for the fund to recover some of its value. Koucheravy says this could happen as soon as the end of 2009, as the credit crisis resolves itself.