Property – from lockdown to lock up

From the first few hours after the Brexit referendum result in 2016, physical commercial property funds have been in the headlines, with investors discovering that daily-dealing funds become anything but when the commercial property market looks uncertain. This was replicated in late 2019, when M&G suspended its Property Portfolio fund due to a lack of liquidity, and then again when all of the open-ended funds suspended in March this year due to the uncertainty of valuations as a result of the coronavirus.

Over the last few months, it became clear that the FCA was moving towards a position where daily dealing in property funds was likely to be banned and we have now seen the proposals that would make physical property funds have notice periods for redemptions from between 90 and 180 days. In its consultation paper, the FCA acknowledged that the liquidity mismatch has the potential to cause harm to investors and it is clear that the current policy of telling investors they can’t have their own money back when they want it for their own protection is one that undermines investor confidence in the whole industry.

We’ve been very vocal on this topic for a long time, calling for a solution that matches the liquidity of the underlying assets with the dealing frequency for investors. The issue was always one that had to be led by the regulator as there was no ‘first-mover’ advantage in any asset manager taking this first step. Moving to a deferred redemption approach makes a lot of sense and ultimately will allow those investors who want exposure to physical property in an open-ended structure to potentially get better returns, as more of their money will be invested in physical property rather than being kept in cash to meet redemptions.

However, it does beg the question, who will want to invest in physical property funds if they have to wait for 90–180 days to get their money back? The answer to that could well be ‘not many’, and that creates some serious challenges for the sector.

Right now, the funds are suspended, so no one can access their money, and this is due to the ‘material uncertainty’ rule – which actually doesn’t become effective until September, but was adopted early by asset managers. However, we are actually getting closer to greater clarity around property prices and it shouldn’t be too long before funds start reopening and being priced again. And this is where the problems will begin.

With the likelihood that new rules will come into force in 2021, we can be fairly certain that many investors who currently have their money in these funds will want to get out before they have to give a notice period.

As a result, we now have the highly probable situation that the funds will reopen and will immediately be hit by a wave of redemption requests, which in turn will force the managers to start trying to sell their underlying properties to meet these requests. Clearly, this is currently a very challenging market to try and sell into, which could create further issues. The reality is that it wouldn’t be at all surprising if some property funds that are currently suspended due to pricing uncertainty will then have to suspend again due to liquidity uncertainty before the new rules even come into force.

With so many advisers using model portfolios of some sort or another, it’s simply the case that physical property funds with a long deferred redemption period just aren’t compatible with the model structure. In the AJ Bell Active MPS, we have had no exposure to physical commercial property since our launch in February 2018 for exactly these reasons, as we feared the liquidity risk that came with the funds in their current structure was too great for the potential returns that came with it. With these latest proposals, open-ended physical property will effectively be off-limits for many investors and the potential wave of selling will only exacerbate the problems that the sector is facing.

This does create an opportunity for the closed-ended sector to push its case as a viable home for investors wanting physical property exposure. Of course, there is no such thing as a free lunch, and therefore investors need to be aware that the trade-off for daily liquidity in the case of investment trusts or REITs is the potential discount to NAV that these trusts could trade at. This is evident right now, with the larger broad-based physical property investment trusts trading on discounts of between 20% and 50% to the stated NAV. Still, at least you can sell if you want or need to!

While some, including property asset managers, will see the FCA’s proposals as draconian, the reality is that structural liquidity mismatches are an accident waiting to happen. In this instance, in my view the FCA is acting in the right manner and I’m sure the whole industry will welcome any actions that help improve investor confidence.