Open ended funds are available in a variety of flavours depending on your need for liquidity relative to your need for real estate returns. In future funds must build in the capacity to withstand mass redemptions, as Robin Goodchild reports
Open Ended Funds (OEFs) are a crucial part of European real estate and play a significant role in the global market. The basic model on which they all operate has weaknesses as well as strengths and, at a time of market stress, the weaknesses come to the fore. Now is the time to examine lessons that can be learnt to see if enhancements can be made.
The importance of OEFs is undeniable. German OEFs have gross property assets of €85bn making them the largest single investment group in Europe. UK OEFs hold assets of £20bn (€23.5bn) so represent 15 % of their domestic IPD Annual Index. US OEFs have total assets of $60bn (€42.1) comprising 23% of the NCREIF Index. Moreover, 10 other EU member states have OEF regimes so the model is widespread.
All OEFs provide for units to be bought or sold at a price based on the underlying net asset value of the fund, using independent appraisal of the property portfolio. They also specify how quickly units can be redeemed for cash. Thus the value of an OEF unit is directly linked to its private property market, hence the connection with direct ownership.
The OEF product is an ideal way for most retail and institutional investors to access the commercial property market. The main alternative is the public market and, with widespread adoption of REITs globally, this is now more comparable as investors are not subject to double taxation. But REIT pricing is more volatile because they are part of the public markets, so OEFs remain the closest form of investment to actual property ownership.
While the principle of the OEF model is well understood, it has been implemented in significantly different ways in various national markets.
The German OEF model emphasises liquidity so unit holders can redeem immediately based on daily pricing. This is achieved through a requirement to hold between 5% and 50% of assets in liquid investments such as cash or bonds. As a result this cash element affects the overall performance through diluting the pure property return. If the liquidity level of an OEF falls below the threshold then the redemptions can be suspended for up to 24 months while the liquidity buffer is restored. In 2002/3, when inflows into the OEFs were extremely heavy, the funds became ‘forced buyers' of property to ensure their liquidity did not exceed the 50% maximum. If it had, the funds would have had to halt the sale of new units.
German OEF appraisal to determine unit pricing is specific. Each property in the fund is revalued every 12 months on the anniversary of its purchase. The unit price is adjusted every 10 days to reflect the level of liquidity as well as property valuation changes. There is no bid/offer spread to adjust the unit price as used in other markets to reflect buy/sell transaction costs. Instead transaction costs are amortised over the expected physical life of properties rather than written-off immediately.
The result is a product that has limited volatility with less exposure to market movements.
UK OEFs are different. The unit price is calculated monthly or quarterly based on a revaluation of all properties. For institutional funds, assets held are solely properties; there is no liquidity buffer. OEFs designed for retail investors are required to hold liquid assets which can be cash, bonds or REITs. They provide daily pricing and immediate liquidity, while institutional funds redemptions normally require a month's notice. In both cases there is a bid/offer spread so that new unitholders pay the notional transaction costs that would be incurred if a property was acquired with their capital while the bid price reflects sale costs.
In retail funds when inflows are strong, existing unitholders could sell at the ‘offer price' because there was plenty of demand for units at that level. The selling unitholders would then receive in excess of NAV, something that should not occur in a world that assumes OEF investment is the same as owning direct property.
The purist UK approach requires redemptions to be paid through selling properties rather than out of a liquidity buffer. Yet it inevitably takes time to convert a property asset into cash and, in volatile markets, the price achieved may be materially different from the last valuation. The advantage of the UK approach is that the return produced is solely from property; it is not affected by cash returns from the liquidity buffer.
The US approach has common elements with both the German and UK OEFs but the outcome is distinct. Like the UK model, funds hold direct property only without a liquidity buffer. As in Germany they place less reliance on frequent valuations of the whole portfolio. However, there is some recent evidence that US OEFs are starting to increase valuation frequency for the whole portfolio to quarterly.
The US redemption promise is much more nuanced than for either the UK or Germany. Managers have more discretion over when to redeem units so are not under pressure to sell assets at times of thin market activity. This is similar to how an actual property owner would act so is more consistent with the general philosophy of an OEF as a substitute for direct investment. However, investors do have less certainty over when their holding will be converted to cash.
What is the solution? There are no easy answers when there is an inherent incompatibility between immediate liquidity and real estate.
German OEFs are successful in attracting capital in their domestic market. But returns are low compared to property products elsewhere, partly because of the dilution from the cash in the liquidity buffer. Moreover, the appraisal process is criticised because German valuers are slow to mark-to-market. And there are concerns that the reported figures would not be realised if the properties had to be sold, implying the unit price is too high.
UK OEFs can be regarded as cyclical products that change with investor appetite for property. The model is not robust and, when the market declines, the redemption promise cannot be honoured. This may not concern long term investors who are prepared to hold units through a downturn but the overall quality of the fund can be adversely affected through being forced to sell better properties to raise capital to meet redemptions. Not all properties can be sold in a weak market so there is a risk that a fund's crown jewels will be disposed of, so reducing returns in the future.
US OEFs are much more robust in terms of preventing the underlying quality of the fund being damaged through fire-sales while still providing a return in line with direct real estate. However, the redemption promise is weaker and some investors will be reluctant to commit on this basis. Nevertheless, the US model is well established and has operated through a number of property market cycles, being accepted by institutional investors looking for a true proxy to directly-held property.
So, retail investors should prefer an OEF with a significant liquidity buffer so units can be redeemed quickly. Institutional investors will prefer an OEF that delivers returns close to direct property ownership but at the expense of ready liquidity. Whatever model is chosen, the fund must be sufficiently robust to operate through severe market downturns when large numbers of unit holders will want to exit, without having to rely on contractual small print.