In the aftermath of the Global Financial Crisis many commercial property funds suspended trading. Some eventually went bust, returning only a fraction of invested capital or worse, nothing at all. The reason for this spectacular failure was leverage – these funds had borrowed heavily to acquire properties.
This time it is different. Since the UK voted to leave the EU commercial property prices have fallen. Companies shy away from buying, building or developing properties when political and economic uncertainty is high. But the funds that have suspended trading this week do not use huge levels of leverage to deliver returns so there are no massive bank loans to repay. But they do not want to be forced to sell property into a falling market so they have suspended trading or applied huge “fair value” adjustments to deter selling. They want the luxury of waiting it out, at the expense of investors, who want out.
Open ended commercial property funds are not liquid although they can appear to be at first glance. They usually price every day, giving the illusion that your holding is able to be sold at a particular value. But as anyone who has tried to buy and sell a house knows, property does not get priced every day and property can be difficult and slow to sell. It is no different for a fund, and if everyone leaves together, there will be a queue at the exit.
Investors have recently run for the door, only to find it is slammed in their face. That liquidity was an illusion. The funds cannot find the cash to pay all the investors who want to leave.
A closed ended fund is a more sensible legal structure for a commercial property portfolio. The properties don’t need to be sold because the number of shares in the fund never changes. Buyers and sellers are matched on the market, just like for any other share, and the market price moves accordingly. As a seller of a closed ended fund you might suffer a lower price but you can get your money out. In doing so, a buyer will likely want a bargain. The fund manager does not even need to be aware of the transaction. The assets managed remain unchanged.
The UK needs leadership and a clear direction on how it plans to leave the EU. Only then will companies be able to make decisions over their futures. And only then will there be some clarity within the commercial property sector. Difficult times may lie ahead for commercial property investors if this drags on longer than it needs to or if the resulting agreements make the UK a less attractive destination for capital investment, both from overseas and from within.
The good news for Courtiers clients is that we have no exposure to such commercial property funds within any of our Courtiers funds. If commercial property prices fall dramatically there may be opportunities to pick up a bargain, but never via an open-ended fund – we value liquidity too highly for that.
Caroline Shaw CFA, MEng (Hons), Dip PFS, IMC, Chartered MCSI
Head of Fund & Asset Management
Transcript of Video:
What has happened to the UK commercial property market?There have been two things that have happened in the last couple of weeks and those things have both been as a result of us voting to leave the EU and the huge uncertainty in our political and our economic future now. So the two things that happened are that investors have decided to run for the exit. After three years of really good returns from commercial property - returns each year of between 5% and 11%. Investors have decided that with this increased uncertainty now, they'd rather leave the commercial property market alone. And alongside that commercial property funds have taken a look at their property portfolios and said 'we need to revalue these now in light of this uncertainty'. So that's what's happened over the last couple of weeks.
Which property funds have been affected and how?Well I'll address the ‘how?’ first. There are two things that property funds have broadly been doing, and most of it's happened this week. So firstly, they've looked at their property valuations. Normally they value monthly or quarterly, and they’ve just revalued with this new uncertainty we've got, and most of those valuations have gone down significantly - most by about 15-17%. And we've seen these fair value adjustments that the property funds have applied and reduced the value of people's holdings by 15-17%. That's the first thing that's happened. And the second thing that's happened is that they've suspended trading. Now property funds have done one or the other or both. And what we've seen is in a market that is relatively small for choice, there are around about 50 funds in the UK - listed in the UK investing in property - but only 26 of them focus on the UK, and of those two thirds of them have already taken one of those steps; either the fair value adjustment or the suspension of trading. Which means that across the board, this is a wholesale action on behalf of the commercial property funds meaning that people can't get their money out. So the big four that have been on the news this week; M&G, Aviva, Standard Life and Legal and General, managing well over ten billion pounds worth of assets have all done one of those above things, but other funds have also followed suit.
Are commercial property funds really liquid?Commercial property funds - they're not liquid at all, it's an illusion, certainly in the open-ended space, and if I just explain the difference. You can have an open-ended fund or a closed-ended fund. Now, in a closed-ended fund there are a certain number of shares, let's say a thousand shares and there will never be more or less shares. So if you own one hundred shares and you want to get rid of those shares - sell them - you have to find a buyer for those shares. So the stock market takes care of that liquidity and it's dealt with by the price falling slightly in an environment like this to attract other buyers, but you can always sell your shares at a price. Then on the other side, well, for a manager managing those assets on the closed-ended side that's great, because you know you always have a thousand shares. So you can keep that property and if people want to exit their position, you don't need to sell a property to raise the money to give them their money back. Another buyer gives them the money, so it's a great position for a property fund manager to be in. On the open-ended side, let's say there are a thousand shares in a fund and you want to buy shares, they create another hundred shares for you and it becomes one thousand one hundred. You want to sell those shares it goes back to a thousand but the manager of that property fund has to find the cash to give you back, and if they don't have the cash because they're invested in commercial property and it's not liquid, you can’t just go and sell it on the stock market like you can with a Vodafone or a Glaxo share. You have to go and sell a big property and it takes six months or so to sell a property. If you have that sort of structure then you can't get your money out very easily because they can't give you that money. So what the property funds do of course is they say ‘no, you can't have your money’ and they keep it whilst they sell property to raise that money. So this daily price that a property fund produces - an open-ended property fund gives you a daily price - but you can't get your money out on a daily basis, not guaranteed. So no, liquidity is an illusion.
What’s the impact for Courtiers Investors?Well we have no exposure to these open-ended commercial property funds. We made the decision not to invest in commercial property directly. That was an asset allocation decision. However we do have some indirect commercial property exposure via stocks (companies) that are listed on the Stock Exchange. Now these have suffered some volatility recently and some stock price falls recently as a result of the volatility and the uncertainty caused by the vote to leave the EU. But with these, of course, at least you can get your money back.
What should commercial property fund investors do now?If you are a commercial property fund investor this is a difficult time, because of this uncertainty, and in my opinion, until we have more clarity over the future of the UK within Europe/outside Europe with its political situation resolved - we need a prime minister in place, we need a leader of the opposition and we need that political governance structure in place, and we need an economic future mapped out. And until those things are a bit more certain, this outlook from commercial property is very difficult because companies cannot make decisions on developing property, expanding premises, building property and making any choice on their business direction until we as a country have economic and political certainty going forwards.
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