Marc Haynes asks what we have learned from the recent crisis affecting property funds.
- Are open-ended funds appropriate vehicles for investing in inherently illiquid investments like physical property?
- Even long-term investors who choose to remain invested may experience losses as managers sell assets to meet redemptions
Brexit turmoil has unleashed a wave of redemptions in UK open-ended direct/private property funds, forcing a growing number of providers to suspend trading.
The surprise is not the 'gating' of these funds, but that a key lesson from the last crisis has been ignored: open-ended funds are, in our opinion, fundamentally inappropriate vehicles for investing in inherently illiquid investments like physical property.
To paraphrase Oscar Wilde, to gate once may be considered a misfortune; to gate twice looks like carelessness. Presumably managers thought things would be different this time and enhanced liquidity buffers would provide adequate protection against substantial withdrawals linked to market stress.
Sadly they have not, and if anything is different it is the growth of model portfolios and managed funds services, one of the unintended consequences of recent regulatory reform. This has concentrated decision-making, enabling asset allocators to shift tens of millions of pounds at the push of a button, thereby exacerbating the problem.
Investors suffer through redemptions
At the bottom of the open-ended property funds' house of cards are investors: the ISA investors who want out of a falling market, the defined contribution pension investors who wish to switch funds to protect hard-earned retirement assets, and even the long-term investors, willing to ride out the storm but who will inevitably crystallise losses as managers are forced to sell assets in a deeply unfavourable market.
It is a troubling time, too, for investors in funds that have not yet suspended redemptions. Many of those funds may be employing additional liquidity facilities, such as lines of bank credit to fund redemptions, leaving remaining investors potentially highly levered and exposed.
Reasons to be optimistic
It is a welcome relief that both the Bank of England governor Mark Carney and the new FCA chief Andrew Bailey have entered the fray and expressed concerns about the inherent liquidity mismatches of these fund vehicles.
When suspensions are eventually lifted, we are optimistic that memories won't again become short and that the industry will address the structural flaws of open-ended direct property funds and implement a ban on daily dealing.
This will likely reduce their appeal to retail and defined contribution investors, but perhaps it is time we follow the lead of investors in the US and other regions and embrace the listed real estate market, which has developed dramatically over the last decade
Real estate securities are a natural fit for open-ended vehicles given they provide underlying liquidity, and the funds that invest in listed securities have been successfully 'stress-tested' through the financial crisis and again today.
Let us not also forget that the listed property market presents many other advantages over direct investments, which we believe makes it inherently more attractive to investors seeking diversified exposure to this important asset class.
Improved liquidity can help navigate market cycles
The high level of liquidity afforded by public equity markets provides efficient access to and management of capital and daily market-cleared prices. Real estate investment trust (REIT) fund managers have the ability to manage through cycles by making tactical calls on geographies and property sectors that would be impossible to make in the private sector.
REITs also offer compelling performance. Historically, real estate securities have offered strong returns relative to direct real estate, coupled with above-average dividend yields. This is due in large part to the minimum distribution requirement for companies structured as REITs.
The vehicles also have a history of consistently raising dividends, resulting from cash flow growth that can come organically from rising rents and occupancies, or externally from development and acquisitions.
REITs offer the opportunity to diversify geographically
It must be noted the present crisis is a uniquely British one, compounded by the narrow domestic focus of most of the large open-ended direct property funds.
Real estate securities funds present the opportunity for investors to achieve much greater geographic and sector diversification, while providing access to a wider range of property markets with different return profiles and cycles. Furthermore, the listed market offers the potential to gain exposure to properties that are extremely difficult, if not impossible, to access directly.
The asset management industry learned a great many lessons from the global financial crisis. However, it failed to adequately address the structural issues of open-ended direct property funds. We must now see reform and better educate investors about the benefits of the listed REIT market.
Marc Haynes is senior vice president at Cohen & Steers
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