NERVOUS investors fleeing the stock market risk being lured into expensive and complex commercial-property funds because of the steep commission payments available to financial advisers.

Last week, the Financial Services Authority (FSA), the City watchdog, launched an investigation into the schemes because it fears many are unsuitable for consumers.

Investors are being enticed into commercial-property funds, which invest in shops, offices and industrial premises, because the sector has delivered healthy gains during the bear market. Commercial property climbed by about 9% last year while shares slumped by 30%.

But experts have warned that some of the funds on offer have exorbitant charges, which are often hidden from investors. The Scottish Mutual Commercial Property plan, for example, has a hefty initial charge of 17.5%. In some cases, the schemes pay commission of up to 10% to financial advisers.

The plans also engage in a controversial practice called “gearing”, which means they borrow money to boost the amount they can invest. Gearing can enhance your gains in a rising market, but it can magnify losses if returns fall.

Last week, one expert warned that the worst examples of gearing in commercial-property funds are reminiscent of split-capital investment trusts.

Experts also fear insurers are using new commercial-property schemes as a dumping ground for old buildings from existing institutional funds.

Standard Life, the insurer, has banned this practice in its new UK Property Income fund. Andrew Jackson, its director of property research, said: “We made a decision that we would not move property from our institutional funds in case it created a conflict of interests. If I were an investor, I would want to see my fund manager seeking assets on the open market so that his motives are not open to question. If they are such good properties, why not sell them?” Scottish Widows transferred about 60 properties from its institutional property fund into its UK Balanced Property Trust, which is aimed at consumers, when the scheme was launched last March. The insurer defended the decision last week. “There is nothing wrong with these properties. They were independently valued before they went into the fund and have produced strong returns since then,” it said.

Most commercial-property plans run by insurers have a certain amount of gearing. The Scottish Widows Balanced Property trust, for instance, borrows up to 35% of its assets; Standard Life UK Property Income borrows up to 40%. Some funds, however, can borrow up to 100% of their assets.

Jackson said: “In a number of instances, the level of debt in property schemes is similar to split-capital trusts. But there is a key difference. Property funds meet debt repayments out of rental income, and most tenants sign long-term rental agreements that cannot be revised downwards. The funds would only be in trouble if the tenants all went bust.”

But the FSA has warned that some funds invest in only a handful of properties and would be particularly vulnerable if the firms that rent their buildings were to collapse.

Taxbriefs, a data provider, urges investors to check if their fund has a safety net. The Close High Income Properties Plan, for example, would breach its agreements with lenders if the value of its assets slid by about 17%. Banks could call in their debts, forcing the fund to sell properties even if market conditions are unfavourable.

The fund has an initial charge of 5.75%, which includes commission of 3% for advisers. The annual fee can be as high as 2.5%, there is an additional charge of 1% on all property acquisitions, and the manager will levy a performance fee of 20% on gains above 10% a year.

Close said: “If the fund’s annual dividend falls below target, we will rebate part of our annual fee. But we also levy a fee if we outperform to incentivise our fund managers.”

The FSA urges investors to check the structure of funds. “Some are not regulated by the FSA because they are based offshore,” it said. “If you invest in these schemes direct, you may have no recourse to our ombudsman service or our compensation scheme.”

Experts continue to recommend commercial property because it is expected to deliver a total return of 6% this year and 8% in 2004, according to the Investment Property Forum.

But they advise investors to make sure they understand how a scheme works.

Bob Clarke of Cluttons, a property adviser, said: “Always check the quality of their leases, which should ideally have at least 10 years to run before expiry, or before the tenant can break the agreement.”

The average lease length for the Standard Life Property Income fund is 12 years, but it is less than four years for Close.

Properties should be spread across a range of sectors and locations.

Clarke said: “Schemes that are heavily exposed to the office market in London and the southeast may suffer in the short term. We expect rental values to fall by 3% this year, which will hit capital values.”