There has been a tectonic shift in the UK commercial property market in recent years, as large companies have reduced their office space and retailers have turned to the internet.
While the coronavirus outbreak has proven to be a structural shock to the market, in some areas it has only accelerated the pace of change.
As soon as the prospect of a nationwide foreclosure was launched last year, a number of investment firms suspended their large-scale open-ended real estate funds, leading experts to suggest again that the time would soon be called on these funds.
Many experts have insisted that open structures are not suitable for commercial property
The recent news that Aviva and Aegon are in the process of completely liquidating their real estate funds could prove to be the final nail in the coffin.
As the regulator tackles the delicate issue of liquidity, the future of commercial property investment in the UK will change and investors will want to consider their options.
Open-ended funds were an ‘idle car crash’
Real estate assets have generally been viewed as a stable and relatively secure source of return over the years, but experts have long been concerned about the inadequacy of liquidity in the open-ended real estate funds offered by L&G and BMO.
Liquidity is the ease with which it is possible to convert an asset into cash without affecting its price.
A number of open-ended real estate funds offer investors daily or weekly liquidity, allowing them to withdraw money quickly. However, the underlying real estate assets are much less liquid and often take weeks or months to complete a transaction.
The funds hold part of the portfolio – typically 20% – in cash and liquid securities to alleviate this problem.
The warning signs of the liquidity of real estate funds have been emerging for several years. In the wake of the Brexit referendum, a handful of real estate funds were forced to halt buybacks as savers rushed to withdraw their money.
In 2019, then Bank of England Governor Mark Carney said: “These funds are built on a lie that you can have daily liquidity for assets that are fundamentally illiquid.”
Since then, open-ended real estate funds have experienced an increasingly turbulent period. M&G was the first domino to fall even before anyone uttered the word Covid-19. From the start of the foreclosure, independent appraisers were forced to introduce material uncertainty clauses, leading a large number of companies to freeze their real estate funds as well.
âThe problem with daily liquidity real estate funds has been somewhat of a slow-motion car crash and unfortunately it will be some time yet before many investors can access the capital invested in these strategies,â said James McManus, CIO of investment manager Nutmeg.
What future for these types of funds?
The successful deployment of the vaccine and the reopening of the economy prompted major investment managers to start reopening their real estate funds.
M&G reopened its real estate fund in April, saying fund manager Justin Upton sold or traded 38 properties for Â£ 702.7million during the fund’s shutdown, reducing the total to 54.
And in response to liquidity concerns, M&G said it would allow actual real estate exposure to drop to 60% in exceptional circumstances to help manage liquidity “for example due to unusually high levels of redemptions by Investors”.
Some companies don’t want to take the risk. Last month, Aegon announced plans to shut down its fund due to liquidity issues, just a month after Aviva Investors did the same.
Aegon has suffered from office closures, with the fund having an almost 25 percent weighting to offices outside of London in the south-east, according to its first quarter figures.
What is the regulator doing about these funds?
Open-ended real estate funds have come under scrutiny from the Financial Conduct Authority following massive fund closings last year.
They considered introducing a notice period that would require investors to wait six months until they get their money back.
He said it would help reduce the risk for investors and the economy of selling assets quickly, rather than at maximum price, to meet withdrawal demands.
He is now awaiting comments on a new structure – the long-term asset fund that was first defined by the Investment Association in 2019.
The LTAF will be an open-ended vehicle that would allow retail investors to access unlisted and illiuqid assets, including real estate and private investors.
He now consults separately on the LTAF and said in May that he would only confirm the specific rules of the fund after the consultation is complete.
Aegon and Aviva’s funds are valued at around Â£ 380million and Â£ 366million, respectively, according to Morningstar data.
They are eclipsed by companies like L&G and M&G with funds valued at over Â£ 2bn, but this suggests that even as the economy begins to recover, the underlying problems persist.
Indeed, money continues to bleed from the sector and between January and May of this year real estate funds suffered cumulative net outflows of Â£ 1.5 billion according to data from the Calastone fund network.
And these capital outflows are likely to continue until the regulator tries to address this liquidity mismatch.
The Investment Association has previously blamed the failures of these types of funds on inadequate action by the regulator, which is in full consultation over a mandatory 180-day notice period for open-ended funds.
This is unlikely to be well received by parts of the real estate industry, but it is becoming increasingly difficult to believe that these funds will be able to continue in their current form.
However, Oli Creasey, equity research analyst at Quilter Cheviot, believes Aviva and Aegon will be the last of the funds to close permanently.
âYou can’t rule it out, but I don’t hold my breath for other victims. The rest of the funds are on the whole bigger, which matters, and have been open for some time and so have likely been hit by panicked sellers before.
What if the Delta variant spreads and independent assessors are forced to re-introduce material uncertainty clauses?
Creasey thinks it’s highly unlikely: “Reviewers would be less likely to do this because none of this is more of a massive surprise.”
Instead, appraisers can focus on individual assets or sectors, like retail and recreation, rather than shutting down all assets altogether.
âIt’s a flawed system,â Creasy conceded. âYou have properties that on a good day can take three months and you are supposed to provide daily cash flow. We would prefer to make sure that investors are properly educated about the risks.
Are there other ways to invest in the real estate industry?
For investors who wish to avoid the risk associated with open funds, they can gain exposure to commercial real estate by investing in closed structures such as real estate investment trusts (REITs).
The closed structure does not have the same liquidity problem as the funds issue a limited number of shares, which are traded on the stock exchange.
âWe have always preferred the closed structure when it comes to investing in illiquid asset classes, such as direct real estate,â said Moira O’Neill, head of personal finance at Interactive Investor.
âThis structure is not perfect, but it does mean that investors can head for the emergency exit if they need to. And, importantly but often overlooked, they can buy as soon as they see an opportunity. ‘
REITs have performed relatively well over the past six months despite difficult rental market conditions. Warehouse REIT, which focuses on urban warehouses, is up nearly 26% year-to-date.
Urban Logistics and Tritax Big Box REIT specialize in logistics centers and saw their share prices jump 10.1% and 19.3% respectively.
They do not come without difficulties, however. REITs are traded on an exchange, which means that their value is based on their share price rather than their net asset value (NAV). This means that investors could lose out during times of market volatility.
âInvestors benefit from liquidity given the nature of equity in the investment, but the return streams do not necessarily look like physical real estate, and the returns tend to be much lower than what can be achieved on the market. physical real estate market (although they are relatively stable), âsaid McManus.
Creasy offers another alternative: âOne answer for investors is knowing that both vehicles exist. Neither is perfect and has different advantages and disadvantages.
“If you want to buy a property in a diversified way, maybe you can combine them both.”
Exchange traded funds are a way to diversify UK retail exposure and provide a lower cost alternative.
iShares UK Property UCITS ETF provides exposure to a range of UK-focused REITs and costs just 0.40% per annum. It is currently reporting 1.8 percent.
However, it remains concentrated: out of around 40 stocks, the top 10 represent 65% of the fund’s exposure, with Segro alone representing nearly 21%.
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