As the economy starts to reopen after lockdown, the commercial property sector is looking to bounce back from what has been a difficult year.
But the vast majority of the UK’s open-ended property funds remain suspended after they were closed as the coronavirus outbreak took hold.
And a recent consultation from the Financial Conduct Authority (FCA), which proposes extending the notice period for redemptions, brings the issue of open-ended funds, and their future, into sharp focus once again.
So will coronavirus be the end of property funds as we know them or is it just a bump in the road?
Open-ended property funds a ‘square peg in a round hole’
The outbreak of coronavirus has further highlighted issues surrounding illiquid holdings in open-ended funds after concerns were raised during 2019, particularly in the wake of the Woodford saga.
The underlying problem with open-ended property funds is the liquidity mismatch between the funds and daily redemption requests.
Daily dealing is attractive for investors because it means they can move their money out of an asset class they want. But the underlying asset – property – cannot be bought and sold in the same way.
As such, fund managers hold large cash balances to manage the risk in daily redemption requests. When outflows are too large, dealings in the fund may have to be suspended.
“People invest in open-ended funds because it is easy to get in and out,” says Teodor Dilov, fund analyst at Interactive Investor tells City A.M.
“But actually what we see with property is quite the opposite. They can get in but getting out is stressful, particularly with uncertainty due to unusual events like coronavirus.”
“Daily redemption and hard to sell assets just do not fit together. It is like trying to jam a square peg into a round hole”, the Association of Investment Companies has said.
In a recent consultation paper, the FCA said that while suspensions can protect investors, “repeated suspensions suggest that the daily liquidity that these property funds offer cannot always be delivered and comes with a price.”
But these liquidity issues reared their head long before the pandemic, with the suspension of M&G’s property fund last December. They have merely been exacerbated by the coronavirus pandemic, as funds rushed to suspend as the outbreak took hold in the UK.
Attraction of commercial property wanes
Coronavirus has accelerated existing trends within the commercial property market which makes it all the more harder to sell assets.
High street buildings are suffering as big firms pivot to remote working on a more permanent basis, and if other companies follow this pattern it could be a big hit to the future of office space.
“Typically in a downturn in the economy, there are going to be businesses that have to relinquish office space where they’ve gone out of business whether they’re downsizing that sort of thing. I think the pandemic will probably be quite a structural shock to the property market in some ways”, James McManus, chief investment officer of investment firm Nutmeg tells City A.M.
The suspension of M&G’s property fund in December was the first warning sign that liquidity was a growing issue.
And the uncertainty of a global pandemic – which sent markets crashing into the red in March – paired with an ailing British high street means property funds could come out the other side looking markedly different, if they survive at all.
“I don’t think it’s the end of property funds but I do think it’s the end for daily liquidity promises on property funds. I think the idea that we treat property funds as just as liquid as equities is an outdated concept and one that looks particularly outdated in the current environment given what’s happened. But it’s been clear to see for a long time,” McManus says.
Property funds may survive, albeit in a new form, but since the outbreak of the pandemic, only BMO and Aviva have reopened their funds suggesting that other firms are unwilling to take the risk in the current climate.
Looming Brexit deadline presents another challenge
It is not just coronavirus that is damaging the market though, the eternal issue of Brexit is further damaging sentiment.
“It’s fair to say Brexit has been probably quite damaging to the property market just in terms of people trying to understand what that means at least and the uncertainty creates”, McManus says.
“The economic slump in the UK makes brick and mortar assets even harder to sell,” says Dilov. “Even though nobody’s talking about it at the moment, Brexit is approaching and we still have no information whatsoever on the future relationship with the EU. That is definitely concerning investors.”
The end of daily redemptions?
The regulator has recognised that coronavirus itself is exacerbating trends within open-ended real estate funds.
Speaking at an Investment Association event in June, chief executive Chris Woolard said: “This crisis, like the aftermath of the Brexit referendum, shows the difficulty for these funds of maintaining a promise of daily liquidity to investors when their assets are inherently illiquid.”
The recent intervention by the FCA this month may finally be the end for open-ended funds as we know them. While the proposal mooted by the regulator offers a plaster, it does not fix the fundamental problem.
“One hundred and eighty days’ notice for redemption sounds good on paper but when it comes to giving notices it doesn’t necessarily mean the funds are liquid enough to chase all of the redemptions,” Dilov tells City A.M.
Like Dilov, the AIC thinks the notice period is not long enough and should be extended to a year, as in Germany.
Chief executive Ian Sayers says: “Would it not be better to set the notice period at a year… but allow managers to reduce it when they can certify that this is appropriate?”
It is a point raised by the FCA and Bank of England in a joint financial stability report, published in December, in that there could be unfair advantages for investors who redeemed first.
The FCA’s proposed notice period should be enough for firms to value the property and sell it on, but the established names will be met with huge withdrawal requests.
Even if the firms do choose to reopen, which is unlikely before the end of the year, the funds will be met with a wave of redemptions that they will still not be able to pay out.
“I probably agree with the FCA consultation… What’s being proposed is pretty astonishing – that we’re moving from a daily liquidity environment today to an environment that could be quarterly or semi annually. That’s not a small change”, he adds.
Investment trusts provide an alternative for investors
So what kind of vehicle should investors look to? Investment trusts, listed on the public markets, could offer a more attractive investment since they trade in equity and there are fewer issues with withdrawals.
“There is no easy way to address the liquidity mismatch,” says Dilov. “We believe an attractive alternative is to invest through an investment trust, so even if the discount is widened to a greater extent, people will still have access to their money rather than being frozen, without access to money.”
Given many are trading at an attractive discount at the moment it may be a good entry point for investors to get into the property market.
“We’re seeing some recovery in rent collections, with some trusts even restating the dividend,” says Dilov. “It might be a positive sign for property as an asset class but again, it is important to pick the right structure for the individual’s profile.”