If we had to choose a word to sum up the most important theme in investment this year, it might be "liquidity". In summer, we saw the beginning of the end for former star fund manager Neil Woodford's asset management empire, as investors fled his funds faster than he could liquidate the assets that underpinned them. Now, liquidity has returned to haunt a section of the market that most investors might already have learned to be wary of open-ended commercial property funds.
The Brexit panic of 2016
In summer 2016, in the wake of Britain's referendum vote to leave the EU, open-ended funds that owned commercial property were forced to prevent investors from withdrawing their money (they were "gated", in the jargon). Why? The fundamental problem is a "liquidity mismatch". Property be it warehousing, office blocks or shops is illiquid. Even in periods of high demand, it takes a lot more time to sell a warehouse than it does to sell, for example, a few thousand shares in BP. But open-ended funds promise investors the ability to withdraw their money on a daily basis in other words, they offer daily liquidity. It should be clear that this is just asking for trouble. If investors want their money back faster than the fund manager can sell property to raise the cash, then sooner or later, a crunch will come.
The Brexit panic was short-lived. Funds mostly re-opened within a few months as investors realised that Brexit was a process rather than an event, and that all business activity in the UK would not suddenly come to a halt. However, deeper structural issues such as the shift away from physical shopping centres to online retail, and increasingly aggressive rent negotiations from those retailers still eking out a living on the high street have continued to take their toll on the value of retail property in particular. Meanwhile, Woodford's woes earlier this year have drawn more attention to the sorts of liquidity issues that wealth managers might once have swept under the carpet.
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The return of liquidity woes
This all helps to explain why last week, one of the commercial property funds that last closed its doors in 2016 the M&G Property Portfolio fund was gated again, due to "unusually high and sustained outflows," which it blamed on "Brexit-related political uncertainty and ongoing structural shifts in the UK retail sector." Assets under management had fallen by more than 25% in the year to 31 October, from £3.5bn to £2.5bn. At the start of 2019, the fund had a cash buffer (from which to fund withdrawals) worth 15% of assets. By the end of October, this had fallen to less than 5%, reports Investment Week, citing FE Fundinfo data. M&G is waiving 30% of its management fee, but that's not much help to investors who are now trapped in an underperforming fund that is now worth even less than they had hoped.
Investors in other open-ended property funds have been rushing to ensure it doesn't happen to them too. The day after the M&G fund was gated, £57m was pulled out of the sector "the worst day all year for real estate fund outflows" notes Attracta Mooney in the Financial Times, citing data from global funds network Calastone. We look at the most vulnerable funds on the left. Yet rather than fret over who's next, a better question is: why own these funds at all?
The problem with open-ended property funds
One benefit of investing in illiquid assets is that you earn a "liquidity premium". In other words, you get paid a bit extra because you know you'll have to wait to get your money out, and that getting your money out might also be tricky in certain conditions. This is thought to be one reason why, for example, smaller companies tend to outperform the wider market over time the extra reward is down to the extra liquidity risk taken. So there is nothing wrong with commercial property itself as an investment.
However, using open-ended funds to invest in the sector makes no sense. Even if you as an investor don't want to avail yourself of the daily liquidity, the fact that a manager has to worry about it at all affects their decision making. If you buy an illiquid asset using a vehicle that promises predictable liquidity, then you are missing the whole point. If the liquidity is managed so that the fund is genuinely liquid at all times, then the manager will always be sitting on so much cash that you'll erode your returns that way. Indeed, on the very day that M&G gated its fund, an article on Morningstar asked: "Are property funds holding too much cash?" Yet if the liquidity isn't managed effectively, then you end up in the situation that M&G is in now, where the manager looks set to become a forced seller in any case which of course means accepting worse prices than you would otherwise expect to get.
There's also the issue of valuation. The net asset value (NAV) of these funds is assessed by chartered surveyors. Yet as Patrick Hosking of The Times points out, "the cosy relationship between property funds and valuers" is "riddled with potential conflicts of interest." For example, surveyors make money on both the buying and selling of properties, and provide the funds with services such as facilities management and collecting rents. Yet they are also then meant "to put on a strictly neutral hat and value their properties" too. Like it or not, "there's inevitably pressure to please the client and to be optimistic".
A look back at the history of investment bank analysis, auditors, and credit ratings agencies all suggest that when professional services firms are asked to act as both independent referee and paid-for service provider to a client, the referee role is first to suffer. Yet even if surveyors are all scrupulously professional at all times, the reality is that the NAV of any commercial property portfolio will always be nothing more than a best guess. If you own a portfolio of FTSE 100 shares, then you can know the value of that portfolio almost to the penny. But every property deal is different. In short, the only people who benefit from the open-ended structure are the fund providers. It's easier to raise money for an open-ended fund and it's easier to accumulate. So it serves the purpose of a financial industry that wants to gather lots of assets that it can then charge a percentage fee on. But for the end investor, there are no benefits at all.
Opt for investment trusts instead
Britain's financial regulator, the Financial Conduct Authority, is looking at potential changes, and has been ever since the 2016 rash of gatings. Yet for the individual investor who wants to invest in commercial property, there is already a solution investment trusts. These closed-ended funds trade on the stock market. When investors want out, they sell to other investors the underlying portfolio doesn't change. So the manager of the trust (who is also monitored by an independent board) need never worry about building cash buffers in case of panicky redemptions. Also, the shares can trade at a discount (or a premium) to the stated NAV in other words, these funds are revalued on a real-time basis, using the wisdom of crowds rather than a static surveyor's report.
If you own open-ended commercial property funds, then we'd suggest selling out at the next viable opportunity and reinvesting in a similar real estate investment trust. We wouldn't underestimate the challenges facing the market (and do wait for the election result) but options that our investment columnist Max King has suggested in MoneyWeek in recent months include giant landlords British Land (LSE: BLND) and Land Securities (LSE: LAND). Both stocks trade on a discount of around 30%, and offer a dividend yield of around 5%.
Which property fund might be next to slam the gates shut?
As we've pointed out several times, there's no good case for investors to own commercial property via open-ended funds. But if you do own these funds, what are the risks?
The M&G fund is now closed to withdrawals. When might it re-open? Ryan Hughes of AJ Bell suggests to Investment Week: "Given how long it takes to sell commercial property it is reasonable to assume this suspension may last three months or longer. M&G also needs to sell enough to raise a new cash buffer, potentially around 20%, meaning they need to sell around £500m of property." So if you own it, there is nothing you can do. To be clear, this is not a Woodford-style, "everything must go" situation. But nor is it ideal for the managers to find themselves going into the market as public forced sellers.
What about other funds? When this happened in 2016, there was a domino effect. However, M&G's fund was in a particularly tough position on this occasion. It has been the worst performer in its sector for the past three years, and is particularly exposed to the worst-hit properties. And property fund withdrawals in 2016 were far more drastic than they have been recently. As Hughes adds, about £1.6bn has been pulled from commercial property funds in the past year. That sounds like a lot but in 2016, £2.3bn was redeemed in the three months around the referendum alone.
So it's not clear we'll see the same wave of "gating" this time. At the end of October, the M&G fund was 5% in cash. Rival funds Aberdeen UK Property and SLI UK Real Estate were quick to note that they hold 12.7% in cash and 15.7% respectively, according to the FT. As of the end of October, Portfolio Adviser notes that the most "cash-light" funds are Kames and Columbia Threadneedle, on 8.6% and 6.3% respectively.
If you hold any of these funds, or others in the sector, don't panic. But do reflect on why you own them even, or perhaps especially, if your fund does have a big cash buffer. After all, that's eating into your returns do you want to own property, or do you want to own an expensive and inconvenient current account? As we say in the main story, the only realistic conclusion is own investment trusts instead.
John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.
He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.
His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.
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