Despite the English love affair with property as an investment, we’ve long held the view that the liquidity mismatch between what’s promised by commercial property funds and that of their underlying holdings should ring alarm bells for investors. As the FCA requests commercial property funds provide them with daily liquidity updates and warnings from the Financial Ombudsmen Service, more so than ever before, investors should be cautious.
It’s often said that the British are obsessed with property. For many Brits, their home will be one of the largest financial commitments they ever make, and many investors see moving up the ‘housing ladder’ as a key pillar in their personal investment strategy. It is also no surprise then that commercial property funds feature in many UK investors’ portfolios – whether DIY (through an investment platform) or held in wealth management products.
Commercial property in itself can be a very attractive investment, due to the its low correlation to assets classes such as equities and bonds, an attractive and relatively secure income stream from the property rents, and the potential for capital appreciation in the value of the property. Commercial property funds meanwhile allow ordinary investors the chance to own a segment of the property market that simply wouldn’t be possible for individual investors – such as warehouses, retail outlets and office parks.
However, the underlying properties do not share the liquidity characteristics of assets such as equities or bonds and investors continue to ignore the risks of illiquidity in these funds.
Liquidity: the degree to which an asset can be quickly bought or sold in the market without affecting the asset’s price. Cash is an example of a ‘liquid’ asset, whilst property is ‘illiquid’.
What has changed since 2016?
Investors tend to have short memories when it comes to the risks involved in property funds, and the continued low interest rate environment has led many to ignore lessons from the past regarding liquidity when sentiment turns in property assets.
The property market is intrinsically linked to the wider economy and can therefore be significantly affected by sharp changes in sentiment. This was evident in the summer of 2016, when investors rushed to withdraw cash from commercial property funds, forcing the funds to write down the valuation of holdings and suspend redemptions, locking investors in. As we approach the UK’s exit date from the EU without an agreement in place, investors are once again becoming cautious on the property sector, increasing their redemptions from property funds1, while many major real estate investment trusts continue to trade at discounts of over 20% to their net asset value2.
In order to provide greater liquidity, many UK property funds have since held higher liquid positions in their portfolio – cash, government bonds and real estate trusts, that can be sold quickly to meet the demand for outflows. However, we believe this does not solve the fundamental problem of a mismatch between the daily liquidity promised by the funds and the more constrained liquidity of their underlying holdings, and we are not alone. In fact, the FCA has proposed guidance that property fund managers ‘should not build up or hold large cash buffers for a long period, merely to deal with the possibility of unanticipated high levels of requests from investors wishing to redeem’3.
The risks are clear to see
Despite these funds continuing to market themselves as providing daily liquidity, regulators and governing bodies are increasingly highlighting the liquidity risks. The Financial Ombudsman Service notes that property funds differ from other collective investment funds because ‘there can be lengthy delays between a consumer asking to withdraw money from a property fund and that money being paid out’4.
In October 2018, the Financial Conduct Authority published a consultation paper on the subject. They noted ‘the need to raise cash quickly in response to investors wishing to sell their units poses a challenge to open-ended funds that invest in illiquid assets, such as commercial property’5, and that ‘Even if it is possible, the fund manager may have to accept a substantial discount to their previous, ‘open market’ value, to achieve a quick sale’.
Describing commercial property an ‘inherently illiquid’ asset, the FCA’s paper proposed that funds would be potentially forced to suspend redemptions from investors much sooner than has previously been the case, at the point at which there is ‘material uncertainty’ about the value of 20% of the fund’s holdings.
While it is possible for all asset classes to suffer from illiquidity, for assets such as equities and bonds this is typically temporary. However, the FCA’s classification of commercial property as inherently illiquid – that is ‘assets which are illiquid even under normal market conditions’ – should be of significant concern for those investors relying on liquidity from property funds.
What is Nutmeg’s view?
At Nutmeg, we don’t own physical commercial property funds in our portfolios. For us, the liquidity mismatch between a fund that promises daily liquidity in assets that can take months to sell has always been starkly apparent – as has the crowding of investors into this space over the last five years.
We strongly believe that liquidity has to work both ways – not just when investors buy an asset, but when they go to sell it too. And not just when an asset class is performing well, but when the outlook has soured.
We believe that investors continue to insufficiently account for the risk of illiquidity in property assets and that the suspension of redemptions in commercial property funds is inevitable should sentiment on UK property worsen.
- Morningstar As at 31 Jan 2019, UK Direct Property Fund flows.
- Bloomberg, As at 01 Jan 2019, Hammerson, British Land, Derwent, capital & Counties.
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