Update: UK Commercial property funds

Mark Weedon is our Head of Research, and was formerly Vice President at MSCI

Update: UK Commercial property funds

In the past few days a number of major fund managers have suspended trading in their publically available UK commercial property funds, with a total value of £14B. This tactic hasn’t been adopted since the financial crisis of 2008.

Managers include Aviva, M&G, Henderson Investments and Standard Life. Aberdeen asset-management has taken a different approach, now deducting 17% from the value of any capital withdrawn until further notice, apparently reflecting the discount required to sell the underlying properties in current conditions.

Fund managers have acted decisively in the face of uncertainty and negative sentiment towards UK commercial property investment in the wake of the Brexit vote, which has led to a huge increase in requests from investors to sell their stakes in the fund. While the action to suspend redemptions can be seen as drastic, it’s not unexpected and the speed of their action demonstrates that lessons have been learned from the global financial crisis, where forced selling by funds, in order to meet redemptions, contributed to prices being forced down by 50%.

Commercial property prices were already at highs not seen since prior to the 2008 financial crisis, with some commentators predicting that the market had peaked earlier this year. Redemptions had already risen to £360m in May compared to £137m in April, a clear sign that investors felt it was a good time to realise a capital return, perhaps believing that there was little room for further commercial property price growth in the UK.

Furthermore, a number of fund managers such as Standard Life, M&G and Henderson had already switched the pricing of their funds from the “offer” to the “bid” price in April and May, reducing the capital return for those selling by 5-6.25%, a clear indication that they were expecting increased redemptions irrespective of the referendum result.

Commercial property is a cyclical asset class, with values closely linked to the health of the economy and the strength of businesses who let premises. In times of economic weakness, commercial property values tend to fall steeply as rental income suffers due to reduced demand and increased insolvency from occupiers, leading to lower quality leases being granted and a higher void rate. With the commercial property market already at, or close to its peak, the damage caused by the referendum decision could cause values to fall more sharply and more quickly, exacerbating a slowdown which was already likely to come at some stage.

How do property unit trusts work?

Investors buy units in the funds known as “PAIFs”, a property version of a unit trust, to gain exposure to commercial property investment. Units are priced daily with the underlying value of the property assets and any cash held determining their value. Investors are usually free to invest or redeem their units at any time, with the current price, relative to the price at which they bought, determining the capital return at sale. The funds also pay a dividend derived from rental income.

With open ended unit trusts, the fund manager is obliged to accept unlimited investment capital and must invest this into property as quickly as is practical. If investment inflows exceed redemptions, the fund manager issues new units and the size of the fund increases, which has been the trend in recent years. A small proportion is held as cash or in liquid instruments to fund withdrawal requests, typically 10%-15%, although managers are keen to keep this as low as possible to reduce “cash drag” which reduces the income return they are able to distribute.

The suitability of this structure for property investment is coming under fire for creating a “liquidity mismatch” as well as for increasing downward pressure on values. Investors are supposed to have ready access to their capital but property can be difficult and time consuming to sell.

The knowledge that funds only hold a limited amount of cash encourages investors to “run for the door” if market sentiment turns negative, increasing the chances that redemption requests will exceed a fund’s cash holdings. Managers are left with the unenviable choice between “dumping” stock at reducing prices in a weak market to raise cash, or by suspending trading, as has now happened on a significant scale in the wake of Brexit. Ultimately the latter course is likely to better preserve property values or at least avoid selling at or near the bottom of the market, which should mean stronger performance for investors in the long term.

Open ended unit trusts differ from closed ended, listed property companies, typically known as REITs. Here investors can trade shares freely on the stock exchange at the current market price, providing the advantage of complete liquidity as well as paying an income dividend. As such, listed property companies can continue to operate as usual even when their share price falls as a result of market sentiment.

However, REITs often trade at a discount to the underlying property value and are typically a lot more volatile than direct property investment, underperforming in the long run. British Land and Land Securities, UK REITs listed on the FTSE 100 have seen their share prices fall by over 20% since the referendum result.

Is Property Partner different to commercial property funds?

All the assets on the Property Partner platform are residential property. History has shown that residential property is far less volatile than commercial, with values maintaining a steady upward trajectory and downturns tending to be infrequent and short-lived. The underlying value of residential property as a home helps support prices even during periods of economic uncertainty and weakened demand from investors. Furthermore, owner occupiers with high LTV mortgages rarely sell for below the value of their mortgage, helping to limit falls in prices, even if transaction levels reduce.

While UK house prices are still subject to market cycles, there hasn’t been any 5-year period since records began over 40 years ago where an investor would have lost money in UK residential, when price growth and rental income are accounted for.

The Property Partner market place acts like a stock exchange, with each asset representing its own market, equivalent to a listed company. Investors are free to list their shares for sale at any time and can exit assuming a buyer can be found at that price. Properties trade at a discount or premium to the underlying value of the asset, i.e. the current share valuation, depending on supply and demand.

Unlike with listed property funds, investors can always achieve the performance of the underlying asset by holding, and selling via our five-yearly exit mechanic, if exit on platform at a desirable price wasn’t possible prior to this.

Property Partner gives investors the opportunity to take their position on residential property, irrespective of current market conditions.

Sources: BBC, Financial times, Citywire, Bank of England, Investment association