Managing liquidity in open-ended real estate funds will always be a challenge, because often the moment when liquidity is required is precisely when it is absent. But Simon Redman explains how factors like a diversified investor base can help create stability
Liquidity in open-ended real estate funds only ever becomes a question for debate during times of market stress, when investors make the same exit decisions at the same time. In normal investment environments, unless there is a problem with the manager or the ability to manage liquidity, it is rarely an issue. It is something that is either managed or is not required because there are no redemptions.
But today we are certainly not in a normal investment environment. Market stress across almost all asset classes has tested the liquidity of open-ended real estate funds to the limit.
Open-ended real estate funds have been suffering from abnormal redemption requests around the globe, with funds in the UK, Switzerland, Germany and the US, in particular, either having to suspend or defer redemptions, because their normal liquidity provisions are unable to meet the current demand.
It is important to put this into context though. The primary motivation for investors seeking to redeem is not necessarily due to a lack of confidence in the funds - as was the case with the German open-ended funds in 2005 and 2006 - it is due to the financial crisis and many institutions seeking to resolve their own liquidity problems.
Also, open-ended real estate funds are not alone; even some money market funds, which arguably should be the most liquid funds of all, have suspended redemptions as a result of the financial crisis. Given the scale of the crisis and the measures that even governments have had to take, redemption problems in open-ended real estate funds are not surprising.
While the current events are extreme, they do not provide the real estate industry with a get-out-of-jail -free card. There are important lessons that can, and should, be learned about the way funds are structured and managed. Direct property is undeniably an illiquid asset, because, unlike publicly-traded securities, it cannot be bought and sold at the click of a button. However, comparing the liquidity of direct property and open-ended real estate funds with that of publicly traded securities is unfair.
The purchase and sale of shares on publicly-traded markets is not the same as buying or selling a property. Transacting shares on a stock exchange involves trading on a secondary market. In other words, it is not the whole company itself that is being bought or sold. Actually buying and selling a whole company is a complex and time consuming business, and while buying and selling a property is also time consuming and complex, it is arguably quicker and easier.
A better basis of comparison for transacting shares would be to look at the ability to buy and sell real estate investment trusts (REITs) or listed property funds where, unsurprisingly, the level of liquidity is comparable with publicly-traded securities.
Although, theoretically at least, comparing publicly traded securities with retail open-ended real estate funds is not really fair, it is exactly what many investors do.
They seek the diversification and performance characteristics of direct property but want similar liquidity to public markets. It is in attempting to do this that open-ended real estate funds can, in extreme circumstances, run into problems. While investors must be made aware of the limitations of direct property investment and its use as an asset class in open-ended real estate funds we can, as an industry, learn from the current environment and improve on how such funds are structured.
Improvements can be made by having a more considered approach to developing new open-ended real estate funds. Two key aspects in seeking to alleviate potential liquidity stress are investment strategies that are less likely to result in investors adopting a tactical approach to investment.
The first is: the more focused a strategy, the more likely it will be subject to cyclical performance and, therefore, the more likely that investors will want to time the market by entering and exiting. Fewer concentrated regional strategies, allowing the manager rather than the investor to make individual market and sector decisions, would be less likely to suffer redemption pressures. Funds that invest in a region rather than a single country or sector, are better suited to an open-ended structure.
The second aspect, which has been largely ignored to date when structuring open-ended real estate funds, is to consider investor behaviour patterns. The current example of UK open-ended real estate funds dominated by retail investors having to suspend or defer redemptions is a case in point.
Retail investors often act in the same way at the same time. Therefore, irrespective of the event, the fact that funds could not cope with redemption pressure was, to a certain extent, inevitable. An answer to this is to adopt a more diversified approach to investors. Having a range of investors with slightly different investment requirements within a fund can help to significantly reduce the risk of all investors seeking to redeem at the same time.
Reducing the potential for mass redemptions and subscriptions becomes far easier when investors are driven by different investment requirements. For example, at any one point in time, even now, there are some investors wishing to invest as well as those seeking to disinvest.
The ideal situation for an open-ended real estate fund would be to match these investment requirements, and the only way to do this effectively is to take a diversified and international approach to these investors.
In conclusion, while it may not be possible to cater for the sort of extreme events we are experiencing at the moment, we can and should learn some lessons and improve the way open-ended real estate funds are structured.
Simon Redman is head of product management at Invesco Real Estate