13 Dec Still want to own commercial property? There is more than one way…
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“It’s déjà vu all over again!”
The fund manager M&G recently announced that it has decided to suspend redemptions on its £2.5bn M&G Property Portfolio fund, following what it describes as ‘unusually high and sustained outflows’ estimated at £1bn over the past 12 months. This is obviously unfortunate for investors, some of whom may well be also stuck in the Woodford Equity Income fund as it goes through the process of winding down. The news also seems to have sparked something of an alarm among some investors in other funds that hold physical property, as redemptions of those have moved upwards .
Yet none of this should come as much of a surprise to investors. After all, every time this happens there are warnings about the risks of a fund which offers daily dealing holding underlying assets, in this case commercial property, which don’t. I recall it happening after the 1987 market correction and several times since then. Anyone who has sold property can attest to how long it can take, even once a buyer has been found. If a buyer has to be found as well, and the sale needs to happen quickly, the price at which the transaction takes place is probably going to be unfavourable to the seller. Even so, the cash will not be available to distribute to investors this week and possibly not even this month.
The same thing happened again in the 2007-08 global credit crisis and again following the 2016 EU referendum, when funds managed by some of the largest names in the business were affected. Clearly the issue is not restricted to property funds either, as recent events with the Woodford fund have shown.
Of course, now that it has happened again, the Financial Conduct Authority has published new rules requiring that the managers of such funds disclose in their fund information that in certain circumstances, dealing may be suspended to protect remaining investors in the event of unusual volumes of redemption requests. Whether it will actually be read by those at whom it is aimed remains to be seen.
The issue with property as an investment is not the underlying asset class per se but the form in which the exposure to it is obtained. Disregarding a derivative-based vehicle which was launched in the last decade and disappeared shortly afterwards, there are two basic ways to obtain that exposure: owning buildings or owning shares, whether directly or indirectly, in property companies. Some do both.
Buildings, as noted above, are difficult (and expensive) to sell quickly should the need for unusual amounts of cash suddenly arise. To accommodate this to some extent, some property funds which invest in bricks and mortar hold higher cash balances than might be found in a typical non-property fund. The 73 distinct UK direct property funds listed in Morningstar’s database, for example, show an average cash holding of just over 14% while the highest holds nearly double that. Retaining a high cash balance is a pragmatic way of avoiding either forced sales or trading suspensions but in the long term, it acts as a drag on performance, assuming that markets work as they should and real assets deliver a higher return than cash to compensate for the greater risk. Of course investors cannot access this cash should they need it so they need to hold their own cash reserve separately and in the meantime they continue to be charged for holding it in the fund in the same way as if the fund were fully invested.
So what of the alternative route to property exposure, shares in property companies? For many years, investors would use these as a way to secure broad access to the commercial property market. However, ‘property companies’ covered a multitude of activities, from managing properties owned by third parties or owning an office block to more speculative activities such as development or holding land banks.
Then in 1960, the United States introduced the real estate investment trust, the REIT. By transferring its assets into a REIT structure, the company could, provided that it met certain requirements, secure some tax advantages. For investors, the fact that the company’s income had to be derived almost entirely from rents in the commercial sector meant that there was no longer the need to rummage in the accounts to determine what its activities entailed.
A further benefit was that, as a publicly listed entity on a recognised stock exchange, investors could buy and sell their REIT holdings through a stockbroker at relatively low cost and with settlement periods measured in days. Transactions are at the quoted market price and if there are more buyers than sellers, the price goes up; if the opposite, it falls. Since the investors simply trade with each other, the company continues its activities unaffected and need not either maintain large cash holdings or dispose of its assets to accommodate sellers.
REITs were introduced to the UK in 2007 and there are now over 480 of them across 38 countries. Each one is an individual portfolio but in order to obtain international diversification, there are funds which invest in multiple REITs and there are even several REIT indices for those who prefer not to try to work out which markets and REIT managements are better than others.
Investing in REITs, whether directly or indirectly, does entail exposure to potential gearing if the REIT has borrowings. While this can magnify investors’ returns in rising markets, it also increases losses in falling ones. Individual companies, as with equities generally, are also not subject to the regulatory supervision that applies to authorised investment funds and so investors are not covered by compensation schemes in the event that it fails. For these reasons, as well as that of diversification, most investors are probably better served by investing in an authorised fund investing in multiple REITs than in individual ones.
Of course suspending dealing penalises everyone, including those who might want to buy rather than sell. With a REIT fund, the price simply moves to reflect the market price, which means that those investors, like us, who just want to maintain their exposure to the asset class have the opportunity to hoover up assets at lower prices. As we know, buying something at a lower price increases its expected future return, which is generally a worthwhile goal.