How to check the foundations of commercial property funds
In the past fortnight or so, a number of open-ended commercial property funds available on the AJ Bell Investcentre platform have suspended trading, instituted fair pricing, or significantly varied the terms of trading, to the understandable consternation of advisers and clients.
This is in response to widespread redemptions, as portfolio builders have attempted to withdraw cash from the funds in a hurry following the UK’s vote to ‘Leave’ the EU, only to find that the collectives have quickly exhausted their reserves of ready cash and liquid assets. Since the underlying assets – buildings – cannot be sold quickly, the funds have decided to suspend trading, until they can build up sufficient liquidity and meet those redemptions.
Those with direct exposure those funds will be the most concerned, but the rough treatment meted out to closed-ended property vehicles, such as investment trusts and the FTSE 100-quoted real estate investment trusts (REITs) means anyone with some exposure to the commercial property asset class may be feeling a little nervous.
Fears that the UK commercial real estate market will take a tumble following the referendum result are understandable.
In addition the closure of real estate funds to redemptions does have unpleasant echoes of the first stages of the 2007-09 Great Financial Crisis, when commercial property was one of the first asset classes to feel the strain as the global system began to creak under the burden of its debts.
But there is no guarantee the bear case will develop. For the moment, all advisers and clients can do is sit tight, be patient and keep abreast of news from the major property fund providers.
Regular investment, regular disinvestment and model portfolio rebalancing may also be impacted while it is not possible to trade in the affected funds, and advisers and clients will have to work around this. AJ Bell Investcentre will not do anything with clients’ portfolios or cash unless directed to do so and any cash which had been earmarked for one of the suspended funds will be left as cash in a portfolio until we are instructed otherwise.
As we all wait for the funds to begin trading again, it may be worth considering the following, using the 2007-09 crisis as a benchmark and acknowledging that it may be possible to take a lead from investment trusts and REITs, which are still freely trading on the London Stock Exchange.
- During the 2007-09 crisis, the big property funds saw their net asset values fall by 41.1% on average, from peak to trough. The fair pricing adjustments made so far come in below that figure, although there is no guarantee the UK will fall into recession or that real estate will fall as hard and fast as it did nearly a decade ago. Perhaps the 2007-09 experience is still a useful benchmark for a ‘worst-case’ scenario, nevertheless.
Big property funds’ NAV per share figures fell by 41% on average during the financial crisis
Source: Thomson Reuters Datastream
- During the 2007-09 crisis, the big three quoted FTSE 100 REITs – British Land, Land Securities and Hammerson - saw their net asset value (NAV) per share figures fall by some 40-50% (adjusting for the dilution caused by rights issues).
FTSE 100 REITs’ net asset value per share figures fell sharply during the financial crisis
Source: Company accounts.
*Note that the figures do not adjust for the dilution that resulted from rights issues. In March 2009, British Land had a 2-for-3 rights issue, Hammerson raised fresh cash in H1 2009 and then again in 2014 (raising 10% of its share capital) and Land Securities had 5-for-8 rights issues in H2 2008. Adjusting for these the average decline in NAV lies in the 40%-50% range.
Intriguingly the share prices of the three quoted FTSE 100 REITs that were around in the current form during 2007-09 all peaked in October 2015, well before the open-ended funds’ suspension.
Since then, British Land has fallen 30%, Hammerson 17% and Land Securities 22%.
FTSE 100 REITs peaked in October and have since fallen sharply
Source: Thomson Reuters Datastream.
While the individual stocks are unlikely to be of direct interest to advisers and clients, they are worth bearing in mind for two reasons:
- The open-ended funds use them as a source of liquidity, so the farther they fall the smaller the potential buffer.
- They can be used as a proxy for just how far the market thinks asset values may fall.
One potential source of comfort is that their balance sheets look much less stretched than they did in 2007. Their superior finances are leading some analysts to argue that the REITs should not fall as far this time around, even if a deep market downturn does ensue.
The big REITs balance sheets generally bear less debt now than they did in 2007
Source: Company accounts
- During the 2007-09 crisis, the share prices of the biggest UK property investment trusts, F&C UK Real Estate Investments and Schroder Real Estate, fell by 60% and 90% respectively, peak to trough
Big two UK direct property investment trusts saw their shares fall by 60% and 90% during the financial crisis
Source: Thomson Reuters Datastream
- During the 2007-09 crisis, the overall Property Direct – UK sector for investment trusts briefly traded at a 38% discount to net asset value (NAV) at its low. This compares to a 10-year average discount of just 2% and a current discount of 9.9%, with F&C UK Real Estate Investments trading at a 12% discount and Schroder Real Estate 13.6%. Both were trading at discounts nearer 20-25% a week ago so someone, somewhere thinks they spotted a bargain. Time will tell if they are right or not.
Source: The Association of Investment Companies, with particular thanks to Jemma Jackson
The share price rally in the F&C UK Real Estate Investments and Schroder Real Estate is intriguing and advisers and clients might like to keep an eye on these two, as a guide to broader market sentiment toward the commercial real estate sector.
Note that they had already peaked in April and July 2015 respectively, a good few months ahead of the open-ended funds, which topped out last October and well ahead of the Brexit-inspired panic to withdraw from open-ended property funds.
UK direct property closed-ended funds began to droop before the open-ended ones – and have already begun to rally
Source: Thomson Reuters Datastream.
Sustained gains in their share prices and closure of discounts to NAV would be a potentially encouraging sign, while fresh falls and wider discounts would be of greater concern.
If anyone does feel brave enough to look at the asset class afresh, investment trusts do at least offer a way in and the table below lists all ten members of the Association of Investment Companies sector, ranked by discount to NAV. Note how the dividend yield averages 5.2%, which may catch the eye of income hunters, although only advisers and clients can know whether any of these closed-ended collectives fit with their specific investment goals, target returns, time horizon and appetite for risk:
The discounts to NAV on UK property investment companies range from a 14% premium to a 14% discount
Source: The Association of Investment Companies, Morningstar for the Property Direct – UK category.
* Share price. ** Includes performance fee
A further alternative lies with Exchange-Traded Funds (ETFs), a relative newcomer to this commercial property asset class. There are two such trackers designed to provide access to UK commercial property although note that European fund rules mean they can only invest in quoted stocks and bonds, not the underlying buildings.
Trackers offer another way to seek exposure to property, albeit via listed stocks not actual buildings
Source: Morningstar, for Property Indirect - Other and Property Indirect - Europe categories
Where more than one class of fund features only the best performer is listed.
AJ Bell Investcentre will continue to keep clients and advisers apprised of developments at the suspended funds. Their last public statements can be summarised as follows:
- Aberdeen UK Property froze dealings from 6 July until 13 July and introduced a dilution adjustment to fair value of 17%, After 12 noon on 13 July, dealings recommenced and investors were able to buy and sell once more although by that time the fund manager had initiated a ‘“total asset property reduction’” of 26%, including sales costs, fair value adjustments and a further discount to reflect the potential impact of having to sell buildings in a hurry and what Aberdeen terms the “relatively penal consequences” of having to do so. Any trades placed during the suspension period were not executed and must be re-submitted – this includes regular dealing plans.
- Aviva UK Property Trust is not accepting instructions to buy, sell, transfer or switch units until further notice, as of noon on 4 July 2016.
- Henderson UK Property announced a suspension of dealing as of 12 noon on 5 July, until further notice. It stressed regular savings plan transactions would not be enacted or back-collected once dealing resumes, and nor will it be possible to reinvest income during this period, so any income received will be distributed. Henderson will continue to assess the fund’s value and once trading recommences any deal will be struck at a price which may differ from the one on offer before the suspension.
- Kames UK Property announced an initial 5% downward adjustment to fair pricing on June and then increased this to 10% owing to continued market volatility on 7 July.
- M&G Property Portfolio announced a suspension of any buy or sell orders from noon on 4 July. The suspension is to be reviewed every 28 days. The fund also announced a 4.5% downward adjustment to fair value to reflect broader market uncertainty.
- Standard Life UK Real Estate suspended dealing from noon on 4 July, a decision which will be reviewed every 28 days. The fund has ceased to collect cash from regular savings and investment plans and will advise everyone once the suspension is lifted.
- Threadneedle UK Property suspended all buy, sell and switch transactions as of noon on 6 July. Dealing will recommence when the fund manager believes it will have sufficient liquidity to meet redemptions and protect the interest of advisers and clients who stick with the fund. Threadneedle will continue to calculate a valuation and publish a daily price on its website and advisers and clients will be able to request a valuation.
Again, it may be worth benchmarking any fair value adjustments relative to the prevailing discount to NAV on the F&C UK Real Estate Investments and Schroder Real Estate investment trusts (plus the overall AIC Property Direct – UK category) as they will represent the wisdom of the market and what is currently being priced in.
One of the biggest funds which has yet to take this step is Legal & General Investment Management’s UK Property Fund, a £2.5 billion giant which has been in operation since 2014.
According to its factsheet dated 31 May 2016, the fund had 19% of its assets in cash and another 6.7% in quoted REITs, to give it a higher liquidity buffer than its peers.
The degree of liquidity buffer varied across the big property funds ahead of the suspensions
Source: Fund providers’ factsheets, Morningstar for the Property Direct – UK category
Via a helpful webinar held in early July, senior fund manager Matt Jarvis outlined the fund’s latest updates on fair value pricing and the bid/offer spread associated with buying and selling the fund:
- On Monday 27 June, the fund initially adjusted its fair value down by 5%. A few days later it made a further downward adjustment of 10%, in light of additional market data.
- Legal and General has also adjusted the spread, which the fund uses as a means of covering property transaction costs up-front for long-term investors. The bid-offer spread has been cut to zero, so new buyers can enter the fund at a lower cost and not affect the interest of existing holders of the fund.
Again, advisers and clients with capital in the suspended funds must now sit and be patient, but at least they can keep in touch with what the market is thinking and how the open-ended funds may be valued when dealings begin by tracking the closed-ended property investment trusts run by Schroders and F&C.
When dealing recommences advisers and clients can then assess whether they feel valuations are appropriate and long-term risk-reward profiles are suitable for their particular portfolio needs, be they income or capital-gain related, or even a combination of the two.