Investors in commercial property funds should be aware of dangers such as lack of liquidity and high costs, writes Laura Slattery.

Irish investors have been swept along on a wave of enthusiasm for commercial property funds over the last couple of years, as volatile equity markets have spurred a search for more stable alternatives.

These funds allow investors to gain from rental income in the short term and capital appreciation in the medium to long term on types of properties they wouldn't normally be able to afford on their own.

But unlike equities, getting out of a property investment is not going to be as easy as picking up a phone and telling your broker to "sell, sell, sell".

Exit routes from property funds can be hampered by wait times of up to six months before investors can take the cash.

So do consumers always know what they're getting into when they invest in property funds?

That question is currently on the minds of industry regulators at the Financial Services Authority (FSA) in the UK. Last week, the FSA announced it was to examine the nature of property funds and how they are marketed to retail investors.

The FSA aims to ensure that consumers are properly informed of the risks associated with property funds. The British regulatory body is also concerned that there may be financial advisers active in the market with a poor knowledge of property investment and therefore a poor ability to properly advise on whether or not they are suitable for individual clients.

The chairman of the FSA, Mr Howard Davies, said there was "ample scope" for consumers to fail to understand the risks involved in indirect commercial property investments, such as a lack of liquidity and high transaction costs.

"While residential property investment is familiar to many householders, the complexities of a packaged investment product and the associated risks may be far from transparent," he said.

Here, unit-linked property funds sold through insurance and investment companies such as Irish Life, Hibernian and Friends First allow smaller investors to put money into commercial property both in Ireland and overseas.

These investors, who will often be more used to the ups and downs of equity-linked products than the peculiarities of property, might not normally have the spare capital to splash on an apartment in central London, never mind an entire block of retail outlets with "blue-chip" tenants and a "prime" location to match.

"A lot of these property bonds are springing up and you have to ask questions," says Mr Ian Mitchell, general manager of financial advisers Towry Law.

It is incumbent on financial advisers to make sure investors understand that property funds are not so easy to get out of if you need money in a hurry, he says.

The FSA's concerns that consumers are receiving poor advice on property funds are already echoed in the Central Bank's rules on advertising in its code of practice handbooks for investment firms and intermediaries.

According to the Central Bank guidelines, advertisements for funds that invest more than 20 per cent of their assets in property must state that the value of the assets is a matter for an independent expert's opinion and the assets may be difficult to sell even at that value.

The advertisement must also state that there may be times when the units cannot be redeemed.

Lack of liquidity is "a possible risk that people need to know about", says Ms Karen O'Leary, consumer information officer at the Central Bank.

"The assumption might be that if you get into a fund rather than actually buying a property, you might be able to sell more quickly," she says.

In property funds, there is often a six-month lag between deciding to sell and the realisation of the assets.

The lag times are actually designed to deter speculative investors from using property funds to make a quick profit. If returns start to slip and large numbers of people look to pull their investment, this could force the fund manager to sell property in a falling market, with everybody losing out.

High transaction costs were the second feature of property funds highlighted by the FSA chairman, although these are significantly lower than they are in Ireland due to the UK's more attractive stamp duty regime.

"We have looked at property syndicates where there are very high transaction costs, particularly if the fund is geared," says Mr Mitchell.

These could be as high as 24 per cent of the bid price. Ongoing management costs can also be significant.

Geared funds are ones where the company running the fund borrows money from banks and adds those borrowings to money placed by investors in the fund. For example, in Hibernian's geared property fund, every €1 invested is matched by €1 borrowed by Hibernian. So for every €1 invested, €2 is actually used to buy property.

On a 100 per cent geared fund, €1.5 million of investors' funds and €1.5 million in borrowings might be used to buy a €3 million property. In Ireland, the stamp duty payable is 9 per cent of the €3 million, or 18 per cent of the initial collective investment.

Gearing increases the potential for good returns, but carries more risk. If property values go down, the loan-to-value ratio on the borrowings goes up.

"The normal profile of someone investing in a property fund would be someone who would be happy to take a medium risk. A geared fund is larger than a medium risk," says Mr Mitchell. Advisers may be pushing geared funds on people who could be more suited to the more cautious option, he believes.

"If you're investing in property, you need to get property advice," says Mr Liam Lenehan, chairman of CB Hamilton Osborne King's new subsidiary for private clients, CB HOK Investors.

On geared funds, it is important to get the best package, so that investors are not exposed on a drop in a value or if tenants don't pay their rents.

"The man on the street buying into a retail fund is not necessarily getting that, or not necessarily getting to see that," says Mr Lenehan. "With some property funds, you don't actually see the property you're buying into and the fees aren't always transparent."

CB HOK Investors sources properties through its international affiliates and assures that even when the number of investors piling into one particular property is in the high teens or 20s, they will be consulted on any sale or refinancing decisions.

According to the FSA, investment vehicles such as single property geared investment schemes may promise to be low-risk, with a blue-chip corporate client renting the building.

"However, such schemes can turn out to be high risk, unless they form part of a diversified investment portfolio," Mr Davies said.

"Your blue-chip corporate may turn out to be the next high-profile corporate failure and, given a lack of liquidity in this segment of the market, it can be difficult to re-let or sell the property."

A good tenant with a reasonably long lease usually gives secure rental income, says Mr Michael Moriarty, managing director of CB HOK Investors. But the property adviser should give investors information on the re-letting potential for a "doomsday situation" where the tenant pulls out.

"Prime retail property will generally be easy to re-let; offices in a secondary location might not be," he says.

It is usually during troubled times that the quality of the financial advice consumers receive on particular investments is questioned. Property is no exception. Oversupply in some sectors of commercial property means office rents are falling and values stagnating.

Mr Lenehan believes returns will continue to be in the order of 5 to 10 per cent.

"Yes, the returns on property are softening, but people have been spoiled by the property returns of the last few years. They've been sparkling."