property funds

By ROBIN POWELL

 

We couldn’t have timed it better. My colleagues and I from the Financial Suitability Forum were halfway through the first of two workshops for financial advisers in December on lessons to learn from the Neil Woodford fiasco when news broke that the UK’s biggest commercial property fund was being suspended.

The administrators of the M&G Property Portfolio blamed “Brexit-related political uncertainty” for causing investors to remove money at an unsustainable rate. They also pointed out that changing trends in the retail sector were having a negative effect on demand for High Street premises.

The fund remains suspended, and it may be many months before investors see their money again. Yet the story has virtually disappeared from the financial pages. When the FCA announced on Wednesday that it had written to fund managers to express concerns about liquidity, conflicts of interest and poor value for money, media attention unsurprisingly focused on Woodford and his under-pressure protégé at Invesco, Mark Barnett.

 

15 consecutive months of outflows

But issues around the suitability of commercial property funds haven’t gone away. UK property funds suffered a 15th consecutive month of outflows in December. Despite inevitable reassurances by product providers about their ability to meet redemption requests, financial advisers have every reason to be cautious.

The biggest and most obvious problem with property funds is that selling a property when you need to is rarely straightforward. Anyone with any experience of the domestic property market knows how painfully slow the house-selling process can be. Selling a shopping centre or an office block is far more challenging — especially in a recession or when prices are falling.

 

“Structural vulnerability”

Despite that, investors have come to expect almost instant access to their money when they want to get out. So around half of all property funds are open-ended and offer daily dealing to investors. As the European Securities and Markets Authority recently warned, that gives those funds a “structural vulnerability”.

Although some funds have been building up their cash buffers in case of large redemptions, a recent report by the rating agency Moody’s showed that the size of those buffers varies hugely — from 30.9% of assets to just 6.3%. Funds from Threadneedle, Royal London, LF Canlife and Kames Capital had the smallest cash reserves. “The risk of contagion is now high,” a Moody’s analyst warned the Financial Times.

 

Are REITs the answer?

You can, of course, reduce liquidity risk by using a closed-end fund instead. Real estate investment trusts (REITs), for example, have that advantage, and are also — at least for now — tax-efficient. But are REITs really as attractive as many advisers seem to think?

In a paper published in November, Nicolas Rabener from the London-based consultancy Factor Research, showed that the investment case for REITs has been overstated. Central to his argument was his contention that commercial property is not as effective as a diversifier as is commonly believed.

Using data provided by the European Public Real Estate Association, Rabener analysed the period from 1990 to 2017, and showed that property stocks and mainstream equities were in fact correlated across markets. What’s more, despite the perception that UK commercial property is less volatile than general equities, his findings suggest that the opposite is true.

In conclusion Rabener wrote, “the diversification benefits (of commercial property) were marginal over the last 30 years. Stated differently, real estate stocks are just not unique enough and introduce additional, unnecessary complexity for asset allocation models.”

 

Higher fees, more risk, lower returns

Recent research from the US should also ring alarm bells. Real estate professor Joseph Pagliari of the University of Chicago Booth School of Business and industry adviser and analyst Mitchell Bollinger looked at the performance of so-called “non-core” or “value-added” property funds and whether it represents value for money.

The answer was an emphatic “No”. Non-core property funds typically charge higher fees and have larger holdings in riskier properties that are still under development or renovation. The authors found that underfunded public pensions, which have shifted to riskier assets in the hope of higher returns, are paying a high price for meagre returns.

 

Complexity risk

One final consideration for advisers considering property funds is their complexity. Property funds are rarely simple, and that includes REITs. As well as property, most of them also contain borrowings. Consequently their valuation is impacted by other drivers than property values — interest rates, covenants, rollovers and maturities, for example.

Complexity is itself a risk. It often results in a lack of transparency,  underperformance, and the enrichment of those who manage the fund at the expense of the investor. True, some property funds are less complex than others. But when they don’t fully understand a fund and how it works, advisers should always steer clear.

 

Conclusion

Investors’ memories are notoriously short — and advisers’ memories can be too. It’s barely three-and-a-half years since liquidity issues last hit the sector. Then, the likes of M&G, Janus Henderson, Aviva and Standard Life were forced to bar withdrawals. It surely doesn’t take a huge leap of imagination to envisage a shock to the economy or the financial system precipitating another crisis.

There are, as we’ve seen, serious drawbacks with property funds. Do the potential rewards justify the downside risks? It’s a discussion that advisers absolutely need to be having.

 

Picture: Anthony Delanoix via Unsplash