Is the liquidity of open-ended UK property funds about to be tested again?
With the chances of a ‘no-deal Brexit’ scenario on the rise (admittedly not necessarily our base case at AJ Bell), concerns over UK commercial property in an open-ended fund structure are being raised again. As a reminder, property fund suspensions were rife shortly following the EU referendum vote, when they became unlikely to have the ability to meet the demands of many investors requesting their capital to be returned instantly.
At the heart of the problem is the mismatch of liquidity between the underlying assets (think large office blocks or retail parks) and open-ended fund structures where investors have the ability to invest or redeem on a daily basis. Commercial properties can take many weeks or even months to transact, while the underlying vehicle continues to promise daily liquidity to its investors. In order to meet the requirements of daily redemptions, funds usually hold substantial liquidity buffers, in the region of between 15% and 25% of their Net Asset Value. These liquidity buffers can consist of Real Estate Investment Trusts (REITs), property fixed income and derivatives, but mostly it’s cash.
Under normal market conditions this strategy has worked well, but problems arise under stressed market conditions. Arguably, however, for investors with long-term time horizons, the liquidity issue should not be overly concerning, and in fact a fund suspension may be in the best interest of the long-term investor. Whilst fund suspensions are never pleasant to experience and should be implemented as a last resort, ultimately this course of action seeks to protect long-term total returns by ensuring the fund’s assets are not sold off at large discounts (known as fire sales) simply to return capital to investors who are in a state of panic. Just imagine the damage to fund returns if, in 2016, all those suspended property funds had instead attempted to sell their largest assets in the market all at the same time.
Following on from the property fund suspensions witnessed in 2016, a wider review was triggered by the FCA. As a result of the review, the FCA is aiming for investors to understand fully the liquidity risks and is looking to make fund disclosures easier to understand. The consultation paper was focused on proposals to reduce the potential for harm to retail investors in funds that hold illiquid assets, particularly under stressed market conditions. The FCA recognised that the fund suspensions generally worked as intended and did indeed prevent wide market disruption. The idea that only closed-ended funds remain suitable vehicles for retail investment in illiquid assets appears to have been rejected. They have announced (on 8 October 2018) plans to impose open-ended funds to suspend redemptions if 20% of the value of their assets becomes uncertain. If implemented, while having a fixed rule may put funds on an equal footing, the issue then sits with the Standing Independent Valuers (SIV), who may find it challenging to provide such guidance as they remain reliant on the transaction market.
So, what’s all the recent hype about then? Well, in December 2018 there was a reported £315 million of outflows (as reported by the FT using Morningstar data) from the sector. In addition, it was reported that the FCA has requested daily updates from property fund managers on the liquidity position of the funds. This does bring a feeling of unease and clearly the direction of flows has been the catalyst for numerous fund groups recently swinging their pricing basis from ‘offer’ to ‘bid’, equating to an instant loss of around 5% or more. For those funds which have the ability to switch their pricing basis that is generally the first step in protecting fund returns. This ensures that those investors who want their capital returned are not unfairly eroding returns for those remaining investors – in essence remaining investors do not then bear the brunt of associated selling costs to supply liquidity for others. Investors need to be aware that at times of stress there may only be one option available and that is to temporarily suspend in order to avoid fire selling of assets. The early action of the FCA here looks to be sensible and prudent but at the same time shouldn’t cause panic selling. As previously mentioned, for long-term investors who do not need their capital back, this situation should have little impact on their long-term investment strategy, while it should be remembered that irrational actions will likely compound the situation and actually increase the risk of suspension.
AJ Bell’s Active portfolios (risk profiled DT 3-8) were launched in February 2018 and at that time we decided to zero weight UK commercial property. We felt property yields had been driven to such low levels that they appeared unsustainable, meaning the asset class could become overly reliant on income with capital growth being challenged. Simply put, potential total returns were not attractive enough, at this stage in the cycle, to warrant exposing the portfolios to the liquidity risks of an open-ended direct UK property fund. One year on from that decision, we haven’t changed our thinking. Instead, absolute return has been used in order to provide diversification benefits in a similar vein to that of UK commercial property but without the liquidity challenges and structural headwinds that UK commercial property currently faces. However, this does not mean we would never own these vehicles, we just simply feel that at this time in the cycle the potential reward does not justify the risk and therefore, from a valuation point of view, we find the asset class largely unappealing currently on a tactical basis.