Property investing: Whither the open-ended funds?

Everyone knows that it is not possible to turn base metal into gold and yet there is often a degree of alchemy involved in finance.

In the case of property, the alchemists would have us believe that if it were only possible to find the right structure it would be possible to turn an illiquid asset into a liquid one.

Toby Courtauld will freely admit that, when Great Portland decided to sell the Facebook building at Rathbone Square, it took a year from initial decision to the receipt of the cash. Sometimes the process is faster, sometimes slower, and sometimes buildings can’t be sold at all.

That is the reality and it is completely at odds with the promise of daily liquidity offered by the open-ended Property Authorised Investment Funds (PAIFs).

Of course, the managers of the PAIFs are sophisticated professionals who know this only too well. They do their best to smooth the path by holding around 10% in cash and by using listed property shares as an additional buffer, which has the advantage of providing both genuine liquidity and comparable returns to property itself.

‘has the advantage of providing both genuine liquidity and comparable returns to property itself’

The reason they do so is that they provide a very valuable service, offering tax efficient property exposure to a wide range of investors – unitised life insurance and pension funds and the new managed model portfolios which have become ubiquitous since the changes required by the FCA’s Retail Distribution Review came into effect in 2013 – all of whom require daily liquidity to facilitate the rebalancing of portfolios and all of whom would otherwise be unable to invest in real estate.

The property world tends not to see itself in a wider context but liquidity illusion is surprisingly common.

It doesn’t matter if it’s an open-ended property fund or a FTSE100 tracker, investors treat them all the same. They invest in small amounts, maybe monthly as part of a savings plan, when they receive a bonus or a legacy or at some moment which reflects their view of the value offered by the underlying asset.

These small amounts add up to a big amount which soon exceeds the regular liquidity in the underlying asset.

In a normal two way market this doesn’t matter but at times of shock, like on the Friday following the Brexit vote, it suddenly matters a great deal. In fact, for a while it is the only thing that matters.

‘Those who chose to sell their FTSE100 tracker on that fateful morning got a terrible price’

Those who chose to sell their FTSE100 tracker on that fateful morning got a terrible price as market makers sought to balance price-insensitive sellers with the few professionals prepared to put up risk capital.

Oddly, sellers of the property funds found prices more or less unchanged creating a one-off opportunity to switch out of property at par into REITs, which were suddenly trading on huge discounts.

Some found this opportunity too attractive to pass up and sucked much of the liquidity out of the property funds in the process.

The panic only started when it became widely known that Standard Life had gated its fund.

Managers across the sector very quickly concluded that they would soon run out of cash and most followed suit.

Perhaps the bravest course of action, taken by Aberdeen, was to apply a 17% liquidity discount and a cooling off period to allow investors to reflect on whether they really did want to sell. In the event, many decided that they were happy with the underlying characteristics of their investment, most notably its income, and decided against.

Overall, about £2bn of property was sold at ‘distressed’ prices out of roughly £25bn in order to meet redemptions and, over a period of months, the funds all managed to re-open and to get back to business as usual.

Except that they haven’t quite got back to business as usual.

In the modern world no compliance department will allow a manager to hold material amounts of cash because to do so would be to second guess the demands of the underlying investors.

‘The panic only started when it became widely known that Standard Life had gated its fund’

If you bought a China fund because you wanted exposure to Chinese equities, you would be entitled to be cross if you discovered that the fund manager was hoarding cash because he didn’t like the market.

So the fact that some of these funds are holding 30% cash suggests that something is amiss. Either they are seeing a steady flow of redemptions and are prudently keeping ahead of the game, or they have decided that this kind of voluntary cash buffer is required to avoid the round-trip costs of buying and rapidly reselling assets in the event of some unspecified future crisis or they are anticipating some sort of future regulatory change once the FCA has concluded its Illiquid Assets Review.

Whichever it is, investors are now suffering a massive cash drag, which is cutting the income distributing capacity of these funds by nearly a third.

While the open-ended funds sort themselves out, investors are committing cash to the income focused REITs like never before.

Tritax Big Box, the poster child for this new wave of companies, raised £250m last October and has just closed the books on another £350m raise, taking its market capitalisation to £2bn.

From a standing start in 2013, Tritax has become the 9th largest REIT on the back of a structural shift in retailing away from physical shops into the distribution chain required to support internet sales.

The combination of a 4.4% dividend yield (now up to 6.4% on the IPO price) with steady capital growth and a compelling investment case has attracted a loyal band of investors.

Tritax is by no means on its own – the same could be said for Assura, PHP and MedicX in the doctor’s surgery sector, GCP and Empiric in the student housing market, Secure Income with its index linked leases and an increasingly long list of smaller specialist vehicles, not to mention the Channel Islands domiciled quasi REITs. An examination of the share registers of these companies tells an interesting story.

The reference shareholders tend to be the big, discretionary wealth managers such as Investec Wealth, Brewin Dolphin and Quilter Cheviot.

This implies that the demand for property income continues undimmed and suggests that the dripping tap of outflows being seen by the open-ended funds represents a reappraisal of the structure rather than disillusion with the underlying asset class. In the short term, this raises a number of questions.

• Can the open-ended funds find a way to remain attractive to those whose choice isn’t restricted by the need for daily liquidity and will these platform investors find a new way to access the real estate market while avoiding the cash drag currently associated with the open-ended funds?
• Faced with declining assets under management, will the manager of one of the open-ended funds opt for REIT status? And, if so, how will the others respond?
• Will REITs become the default route into property for private investors – whether self-directed or via platforms or discretionary wealth managers?

Leaving aside the Brexit panic, the investment climate remains benign for all of these vehicles with an almost infinite demand for a 4.5% dividend yield supported by secure cash flows.

‘the investment climate remains benign for all of these vehicles with an almost infinite demand’

However, the tide will, one day, turn and the selling pressure, when it comes, will last for more than a few days.

It is hard to see how the open-ended funds deal with this other than to keep selling assets and it will be interesting to see what the FCA’s Illiquid Assets Review has to say on the subject.

Unless they find themselves over-borrowed, the REITs won’t have to sell assets but they will feel the strain through their share prices.

The resultant discounts will choke off new issuance and will establish trade-offs between the demand for liquidity and sufficiently high yield to attract new buyers which may create interesting investment opportunities as well as having implications for the valuation of the underlying assets. But that is surely for another day.