Open-ended real estate funds have had a longer foreclosure than most. After suspending negotiations due to “material uncertainty” around real estate valuations at the end of March, the majority of open-ended and directly invested real estate funds have still not reopened their doors to investors wishing to buy or sell.
After spending six months trapped in funds, investors may finally see a light at the end of the tunnel after a forum of valuation specialists from the Royal Institution of Chartered Surveyors lifted material uncertainty clause on prices of most UK real estate. This gives hope that the funds, which raised this uncertainty when trading was suspended in March, may begin to reopen in the coming months.
Threadneedle property in UK (GB00B1Q1SR62), a fund with more than Â£ 1 billion in assets, has already chosen to resume trading on September 17, with Property L&G United Kingdom (GB00BK35DV33) is slated to reopen in October. Others could possibly follow suit. But after the second episode of massive suspensions in four years, investors looking to gain exposure to real estate should reconsider their options rather than loyally cling to open portfolios plagued by structural problems.
Structural problems persist
While this year’s suspensions are linked to external events, real estate fund managers can still struggle to manage assets in an open structure when investors get started. While investors can sell units of open-ended funds and expect a payback within days, selling a property to meet such demands can take months. This liquidity mismatch was at the root of the problem both when several funds were blocked in 2016 and when M&G real estate portfolio (GB00B89X8P64) suspended trading towards the end of 2019, after being rocked by “unusually high” volumes of redemption requests.
Investors were ditching direct real estate funds before the foreclosure took hold (see Chart 1), and potentially have even more reason to rush now. Some will feel skeptical about a fund exposed to retail and office buildings such as department stores in the wake of the coronavirus pandemic, while others may just be tired of a structure that appears systematically restrict their ability to buy and sell positions.
Brexit uncertainty is looming again on the horizon. With a messy no-deal scenario looking more likely, sentiment towards UK real estate and the funds that support it could weaken further. Another exodus of investors is not entirely unthinkable. Funds capable of handling massive outflows will likely do so by building up large cash reserves, which may reassure remaining investors, but may also dampen returns.
Other structural problems may also be unnecessary. Some open-ended real estate funds may manage the flow of investor money in part by using a âswingâ price structure to reflect the costs of buying or selling real estate. âLongâ pricing, for example, used when there are more sellers than buyers, effectively lowers the net asset value and makes it less attractive to sell your units.
This sometimes provided investors with tactical opportunities to buy low and sell high. But some funds, like Property Janus Henderson United Kingdom (GB00BP46GG64) have since moved to a “full distribution” system, where all investors initially incur higher costs. This helps ensure that all investors are treated equally, but can deter those who like to plan their investments tactically and take advantage of different prices.
Regulations also threaten to change the profile of the open real estate sector in a number of ways. Financial Conduct Authority (FCA) rules due to come into effect at the end of this month require some funds focused on illiquid assets to suspend trading when an independent specialist expresses significant uncertainty about the value of 20% or more of their assets. This could mean that, as with the start of the foreclosure, extreme events could be accompanied by a series of real estate fund suspensions in the future.
In a new twist, the FCA separately proposed a notice period of between 90 and 180 days for investors looking to withdraw their money from open real estate funds. The proposal, which is currently under consultation, could address the liquidity imbalance and eliminate the need for real estate funds to hold high levels of liquidity at the expense of potential returns. But in a world where investors favor day-to-day trading, it could also significantly limit the popularity of open-ended funds and hamper investors looking to reshape their portfolios in a timely manner.
Many have abandoned the open format some time ago. Richard Champion, Deputy Director of Investments at Canaccord Genuity Wealth Management and one of those who did, notes: âIt’s inherently an unsatisfactory outcome when you can’t get out of an investment.
âIn the past, open-ended real estate funds transported large amounts of cash and held listed securities to try and provide liquidity when needed, but our experience has not been satisfactory. Even with 15 to 20 percent [of assets focused on] liquidity, some funds would refuse to use it to deal with redemptions and the door nonetheless. “
While some funds are already poised to reopen, some wonder if others in the industry will immediately follow suit. Rather, managers may want to judge possible cash outflows that could follow and whether they have enough cash to cope with redemptions.
âFund managers will be absolutely desperate to avoid a scenario where the fund reopens and then a week later is forced to close due to liquidity issues,â said Oliver Creasey, equity research analyst for Quilter Cheviot. âThat’s why they may not rush to reopen until they understand their customers’ intentions. Instead, they can try to let others come first and assess the likely impact. “
All of this suggests a sensible and cautious approach, with funds probably constituting large cash positions first, to deal with massive outflows (see recent cash positions in the graph below).
As such, any return to the status quo may seem wise and managed in a reassuring manner. But investors should remember that the flaws inherent in open-ended funds that hold illiquid assets have not gone away. The time may have come to consider the alternatives.
Property as an asset class is probably not dead. The difficulties of offices and shops are perhaps overestimated, while specialized real estate, from social housing to retirement homes, retains its appeal. Any Brexit outcome could – ultimately – translate into more certainty for the market and for sterling assets. Some would also argue that, at least in a pre-Covid world, real estate has served as a diversifier for equity exposure, a reliable income game and a buffer against the ravages of inflation.
As with other illiquid assets, investment trusts can be a good home for direct exposure to real estate. As trust shares are traded in the secondary market, there is no risk that an investor exodus will trigger a liquidity crisis for the fund manager. The range of options is also wide: the specialist exposures mentioned above are available through niche real estate investment funds (Reits), while diversified generalist options such as BMO Commercial Property (BCPT) offer a game against the tide on beaten fields such as retail.
But there is no free meal. Investment trusts are often hailed as the ideal hotbed for illiquid assets, but they present a serious problem. If a trust is no longer in favor, investors rushing for the door will likely have to exit at a reduced price, crystallizing a loss. Those who held the BMO real estate trust before the Covid hit will be able to exit their position, but likely at a much lower value than at the time of purchase.
As the chart below shows, this presents buying opportunities for the brave, with trusts in unloved sectors trading at significant discounts to the value of the underlying assets. But like all other stocks, actions of trust are often held hostage to sentiment: something can feel cheap and just never recover.
Investors may otherwise opt for real estate stocks, although this may be a more volatile prospect than physical exposure. Equity-focused funds tend to look beyond the UK, although there are exceptions such as open-ended funds. ASI UK Real Estate Equity Fund (GB00BOXWNN66) and the TR Property Investment Trust (TRY).
Finally, a sort of happy medium exists. BMO Real Estate Growth and Income (GB00BQWJ8794), an open-ended fund, has a mix of direct ownership and shares, with a preference for the latter. Its greater liquidity should allow it to offer daily trading while being less vulnerable – but not immune – to the threat of trading suspensions. The fund was forced to suspend operations in March, but reopened in mid-June.