Whilst it will take more time for some of the long-lasting effects of the Covid-19 pandemic to become apparent, one immediate effect has spurred the financial services regulator to look to increase protection for investors using open ended property funds that are priced on a daily basis. The total investments in these funds across the UK amounts to some £17 billion.
As an asset class, commercial property has a number of attractions, not least that it is an income producing asset (with capital growth over the longer term) and has a low correlation with equities, thus offering some diversification of risk within an investment portfolio.
The issue for the regulator with these funds is what is known as the structural liquidity mismatch. Basically meaning that whilst investors can readily buy and sell units in these funds, the underlying assets of the fund cannot be bought and sold at the same frequency. A typical commercial property transaction may take between two and four months.
What has brought the matter into sharp focus is that almost all of these funds have currently suspended their dealings, leading to a double whammy whereby investors cannot withdraw their money should they wish, and have no certainty when the suspension will be lifted.
There are typically two possible root causes that lead to such suspensions. The first is that, in some market conditions, the fund’s assets cannot be valued with confidence. This is currently the case due to the uncertain economic impact of the current pandemic and how it may affect commercial property occupancy prospects.
The other cause is simply that the redemption requests cannot be covered from the fund’s existing cash reserves. But we have been here before. You do not have to look too far back to find examples of events causing such suspensions – both the financial crisis in 2008 and the EU referendum in 2016 sparked increased levels of redemption requests.
The regulator is concerned that there could be potential unfairness between investors in the situation where increased redemptions lead to liquidity runs on property funds, with the consequence that remaining investors in the fund are disadvantaged relative to investors who cash out. This can arise, for example, where a fund has to sell its most attractive assets to meet redemptions, which can have a negative impact on the remaining fund.
It is this particular issue that the regulator is looking to remedy, given that suspensions driven by abnormal market conditions are unpreventable. The thrust of the solution seems to be a requirement for notice periods of at least 90 days and no longer than 180 days, for redemptions from these funds.
The regulator describes the benefits of its proposals as both “material and ongoing”.
By allowing fund managers to have more time to arrange orderly sales of the underlying properties, the regulator predicts that it could deliver a material increase in returns for property fund investors, due to less ongoing cash being required to be held in the fund which can, instead, be invested into more property assets. This is plausible when you consider that the current cash levels being held is c17% or £2.5bn. In addition, by looking to address one of the drivers of fund suspensions head-on it should improve confidence in this type of investment.
But there are some potential downsides to this course of action.
For those fund managers who operate discretionary mandates to manage their clients’ portfolios, it will be trickier to rebalance the portfolios, as redemption values will be based on valuation points as at the end of the redemption period.
Also, as things stand, these changes would disqualify such property funds from being held within a stocks and shares ISA.
Fundamentally, there is also the general matter of whether or not the property sector will be more or less attractive in a post-pandemic world.
For example, will remote working become the norm and result in the supply of office space materially outweighing demand? What percentage of retails sale diverted online during the pandemic will return to the stores?
Views are mixed and, of course, opinions can change. This was summed up recently by the Group Chief Executive at Barclays, Jes Staley. Having previously stated that big city offices “may be a thing of the past”, he subsequently cast doubt on abandoning their offices with the statement that “it is important to get people back together in physical concentrations”. Opinions and mindsets are clearly changing as we progress through the phases of this pandemic.
Only time will tell if ultimately the new rules, and wider investor confidence, will result in inflows or outflows for property funds.
But property, as an asset class, has survived the lows of many previous economic cycles and has always been proven to be resilient.
With such a lengthy track record, along with its particular investment advantages, it is difficult to imagine that investors won’t continue to give it future consideration.
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