Property funds are shaping up as the next big asset class to trip up small investors, tarnish the reputation of the investment industry and challenge regulators. Just as the managers behind technology funds seduced investors at exactly the wrong moment in 2000, property funds seem to have been guilty of the same unfortunate timing in 2006 and 2007.

The losses from office blocks and shopping centres are never going to be anything like as extreme as the wipe-outs from dot-coms but on paper investors who bought at the top are already looking at ugly losses that could get uglier. New Star Asset Management has just wiped £150 million from the value of its £1.7 billion UK Property unit trust, a second big devaluation. Its units have sunk by 18 per cent since July. Others have also been devaluing their units.

Aviva is plagued by rumours (not denied) that it is in talks with the Financial Services Authority with a view to getting trading suspended in the biggest beast in the sector, the £3.7 billion Norwich Property Trust.

It was only a year ago that almost every major investment house was trumpeting the virtues of commercial property investment. Diversification was the buzzword and the worm on the hook was the mouthwatering track record of commercial property over the previous decade. Herdlike, small investors poured £5 billion into property unit trusts in the 18 months to July. More has been invested in the asset class through insurance company bonds.

Recent events have underlined the difficulty of allowing open-ended investment vehicles to invest in lumpy, illiquid assets like buildings. They have cash cushions but these can quickly be eaten up by a flood of redemptions, at which point funds have to contemplate asset fire sales.

Moreover, the FSA — probably mistakenly — has allowed funds to hold liquidity in the form of property company shares rather than pure cash. Since these shares have more or less halved since January, the cushions are looking thin.

The other problem is valuing the buildings accurately. There aren’t enough transactions taking place to put a reliable price on them. With rents, occupancy and tenant quality all solid, the temptation is to argue that value is unchanged. But that is to mistake how markets work and how real prices are set. Surveyors, who are paid by the fund managers, look conflicted in this regard.

Denying investors the right to sell by suspending trading would be a radical step for any unit trust manager. New Star’s policy of frequent and so far large devaluations looks fairer. Devaluing too slowly is the biggest risk, allowing nimble sellers to benefit at the expense of more loyal or inert unitholders.

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