History has taught us that, in investments, liquidity is always king. That’s why the sudden rush out of commercial property shouldn’t come as a surprise.
The news that some of the largest UK commercial property funds have suspended redemptions from investors will come as a surprise to many retail investors, who have seen property assets as a stable and relatively safe source of returns over the years.
Investors tend to have short memories when it comes to the risks involved in property funds, and the current low interest rate environment has led many to ignore lessons from the past regarding liquidity when sentiment turns in property assets – even when events are as recent as 2008.
– Definition – Liquidity: the degree to which an asset can be quickly bought or sold in the market without affecting the asset’s price. Cash is ‘liquid’, property is ‘illiquid’.1
This crowding of investors into commercial property only serves to exacerbate the problem when the same investors come to sell, as the rush to the exits exhausts the remaining cash piles within the fund, leaving the managers no option but to suspend redemptions as they raise cash from property sales.
— Bloomberg (@business) July 5, 2016
At the heart of this problem is a fundamental mismatch between the promised liquidity of the fund and the liquidity of the assets in which the fund invests. Many commercial property funds offer investors daily or weekly liquidity, meaning that you can redeem your shares, should you wish to do so, on this basis. The underlying property assets are much less liquid, however, often requiring weeks and months to finalise sales depending on their location. Furthermore, any development properties may not be able to be sold until the development work is completed, further lengthening the time to sale.
Property fund managers get around this liquidity issue by holding a portion of the portfolio (typically up to 20%) in cash and highly liquid securities such as government bonds and real estate investment trusts. These can then be sold quickly to meet any redemptions.
However the property market, being intrinsically linked to the wider economy, can be affected significantly by a change in sentiment. Since the UK referendum on the 23rd June 2016, uncertainty regarding the operating and economic environments in the UK has begun to affect sentiment in commercial property2. There have been reports of construction projects being cancelled, and financing for property becoming harder to come by. Uncertainty forces investors to become more cautious, and this has hit property funds hard.
Last week, several of the largest UK commercial property fund managers had to write down the value of their property assets by between 3.75% and 4%, as independent valuers adjusted valuations for a post referendum world. This has stoked fears that valuations could drop further, and that the commercial property market may have peaked, causing some investors to cash in their shares.
This could be the beginning of a vicious cycle in commercial property, where the suspension of redemptions in one fund leads to higher redemptions and further suspensions in others within the sector. As sentiment turns funds could be forced into selling property assets at ever decreasing valuations, as more and more property comes on to the market, meaning the valuation of the fund also decreases. Additionally, the cost of selling physical property is significantly higher than the costs to sell securities such as bonds and equities, further decreasing the investors return.
At Nutmeg, we do not 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 upwards of six months to sell has always been starkly apparent – as has the crowding of investors into this space over the previous five years.
Liquidity is paramount. It is a risk often overlooked by investors, which is why we invest our customers’ money in highly liquid and transparent exchange traded funds.
Our asset allocation process uses in-depth research from our investment team, and focuses on owning the right assets at the right time, and taking only an appropriate amount of risk for the portfolios we manage. Too many investors have ignored the risks presented by commercial property in their search for higher returns but, in investing, history does have a nasty habit of repeating itself.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest.
2. UK construction crashes at fastest pace since financial crisis, Markit PMI figures show – Independent 4 July 2016