Open-ended property funds in the UK have suspended redemptions once again. Are they fundamentally flawed or simply protecting in vestors at a time of uncertainty? Richard Lowe asks industry experts
Open-ended real estate funds in the UK have suspended redemptions due to valuation uncertainty in the market. This pause on liquidity follows previous episodes of ‘gating’ – following the EU referendum in 2016 and during the global financial crisis in 2008. Does this prove that the concept of providing liquidity in an illiquid class is fundamentally flawed, or are these vehicles simply responding appropriately at a time of severe uncertainty?
Are open-ended property funds fit for purpose (making a distinction between retail and institutional funds)? If not, what needs to change?
Sayers: “There is a clear mismatch between illiquid assets and an offer of daily redemption. So no, we don’t believe that daily-dealing, open-ended funds holding illiquid assets are fit for purpose. Furthermore, the Bank of England’s Financial Stability Report last December identified this liquidity mismatch was a potential source of systemic risk.
“While monthly or quarterly redemption windows can alleviate the problem to some extent, severe crises are still likely to present asset managers with an unwelcome choice between a trading suspension and a fire sale of assets.
“To avoid this situation, the Association of Investment Companies (AIC) has proposed that open-ended funds investing in illiquid assets should offer reliable redemption. This means the redemption terms of the fund are matched to how long it would take to sell the fund’s underlying holdings without a fire sale. The basis on which an investor can leave the fund, such as the timescale or price, should not change, no matter the level of redemptions.”
Romano: “Any structure can always be improved. In other markets, quarterly valuation frequency has not posed an obstacle to making a market. An important change in the UK would be to not permit institutional and retail investors in the same vehicle. These investors should and do operate under different rules, so they should not be in the same illiquid vehicles.”
Forbes: “Institutional investors find funds and other unlisted investment vehicles extremely attractive. Most will have allocations to both listed and unlisted real estate. As a result of lessons learnt in the crisis of 2007-09 in respect of unlisted funds, much greater attention has been paid to matching the liquidity of the investment vehicle to the liquidity of the underlying assets.
“To ensure reduced volatility, institutional investors have been prepared to sacrifice liquidity in the funds in which they invest, so we have seen open-ended funds for institutional investors reduce the frequency of redemptions and introduce other measures to reduce liquidity. It became apparent after the 2007–09 crisis that many investors were investing in open-ended funds not because they wanted liquidity, but because they did not want to be tied into the fixed life of a typical closed-ended fund. Investors were paying a high price for liquidity they had no intention of using.
“The more high-profile issues have arisen in funds for retail investors. The inflexibility of investment platforms for retail investors has limited the choice to funds offering daily subscriptions and redemptions. I have been arguing for many years that retail investors should have the choice of investing in funds that offer lower liquidity but provide higher returns.
“There is now, slightly belatedly, a general recognition that the current open-ended fund model for retail investors is not serving them well by offering only a clunky, one-size-fits-all model. The Financial Conduct Authority (FCA) is now considering changes to the regime. It seems to be drawn to universal solutions, so my concern is that we will get a replacement, one-size-fits-all model which still does not give retail investors choice.
“In view of recent press coverage of suspension of subscriptions and redemptions by many open-ended funds, it is worth making the point that it was not a liquidity issue – the funds had the available cash to meet redemptions. It was a function of valuation uncertainty.
“Although there were the predictable headlines about investors being ‘locked in’, even if the manager is unable to make redemptions due to uncertainty as to how that redemption should be priced, institutional investors still have the option to trade on the secondary market, albeit at a price that most found unpalatable. Retail investors do not have this choice.”
Barrie: “We believe funds such as these continue to have an important role to play in a balanced portfolio, providing property-like returns to a range of investors where direct market access, individual management and like-for-like buying power would be impossible.
“Across the spectrum, investors continue to see property as being a key source of return and diversification at a portfolio level, but there is also a need to ensure that liquidity exists at some level. Therefore, the position the funds find themselves in is one which has evolved over time and suits the majority. That said, it will always get more attention during difficult periods in time.
“As with any investment, investors should enter with their eyes wide open. Recognition is needed that there may be times when open-ended property funds need to shut, in the best interest of investors. This was the case recently with industry-wide fund suspensions which have been triggered by valuers enacting valuation-uncertainty clauses, in line with FCA requirements. It was this that was the catalyst for suspensions, rather than any liquidity concerns or mismanagement of individual funds.”
“Given the costs involved in buying and managing property, as well as the inherent illiquidity of the asset class, investments in open-ended property funds should be viewed as a long-term investment by anyone coming into a fund. Institutional investors such as pension funds, the mainstay of the market, continue to view it as such and, with the right strategy, there continues to be a place for this type of investment in a diversified portfolio. Most importantly, a fund structure does not determine performance. Ultimately, that is driven in most part by focus (sector, geography), timing and expertise.
“Of course, in the current environment, there may be a need to look further at structuring. Governance and regulation has been iterative – and could still evolve further – particularly around redemption options. Funds are still relatively recent (in the history of investment) and so there is always scope to review how they are crafted in the best interest of protecting investors.
“With regard to dealing time, the nature of the retail-investor market and the platforms which advise and manage funds means that, operationally, funds must be daily-dealt. This debate is well-trodden and the industry has developed various mechanisms to enable retail platforms to offer direct property funds (rather than listed exposure) while also addressing liquidity mechanisms. These include a requirement to hold liquid assets (cash and REITs) as well as various protection mechanisms such as deferral.”
Haynes: “Lock-ups of daily-dealing, open-ended funds investing directly in real estate – occurring in 2008, then in 2016, and now again – have exposed the inherent design flaw of relying on cash buffers to provide liquidity in times of market stress. Liquidity is rarely an issue when times are good and the supply of capital is strong.
“But when there is a rush to exit, the liquid reserves built into direct property funds can quickly evaporate to fund redemptions. This can force fund managers to close the gates on redemptions, giving them time to raise cash by selling properties, often in a deeply unfavourable market.
“To reduce this risk, open-ended direct property funds are forced to increase cash reserves. However, this additional liquidity is not free. It can cost investors in the form of lost return potential given the low yields on cash equivalents, not to mention the fact investors are essentially paying fund managers to hold cash.
“More importantly, higher cash buffers do nothing to address the structural mismatch of having daily liquidity in investment vehicles where the underlying assets can take months to sell. This flaw forces investors to compromise either liquidity or return potential.
“This issue is exacerbated when considering that these private real estate funds have on average 25-35% exposure to retail. These assets have been difficult to sell, meaning that private funds will sell their retail properties at deep discounts or sell their best assets in order to provide liquidity to fund redemptions. That either results in the crystallisation of potential losses, or a portfolio weighted even higher to retail if a fund is forced to sell off its best assets.”
Richards: “The daily liquid property funds are mostly invested in by private individuals through wealth managers and independent financial advisers. They serve a valuable purpose for these investors in providing diversified access to the property market with the ability to trade in and out daily under most market conditions. There is a cost to this however, as most funds manage this by having a large weighting to cash, which impacts on performance compared with property funds which do not have to hold such high cash levels.
“Under extreme market circumstances, such as the high levels of redemptions seen after the Brexit referendum, or material valuation uncertainty as we are seeing now, these funds suspend daily trading in the interests of investors. This prevents them from being forced sellers at a time of high redemptions, and from issuing or redeeming units at the wrong price at a time of valuation uncertainty. Strict FCA regulations apply, in order to ensure that all investors are treated fairly.”
Is there a need for a new type of open-ended or semi-open-ended structure?
Sayers: “We believe that open-ended funds investing in illiquid assets should offer reliable redemption, where the redemption terms of a fund are matched to how long it would take to sell the underlying assets without a fire sale. Reliable redemption ensures all investors in the fund are treated fairly and removes the potential systemic risk. There are various ways reliable redemption could be achieved – for example, notice periods that are sufficiently long to achieve a sale in both normal and foreseeable stressed market conditions.”
Romano: “The open-ended fund structure has a long and successful track record in the US. What is sometimes an issue is that investors don’t appreciate the level of liquidity they get with an open-ended fund. At best, these funds are ‘semi-liquid’. The investor needs to be comfortable with the redemption structure and the possibility of the gates closing.
“In terms of new structures, longer-term investors are open to exploring new options. There are some global evergreen funds – for example, new capital can be invested or redeemed during a limited window once a year – that invest in the UK among their markets. A UK-only evergreen vehicle is something that would still need to be explored.
Forbes: “We have also seen the development of hybrid funds that combine features of open-ended and closed-ended funds. Aberdeen Standard Investments’ Airport Industrial Property Unit Trust was arguably the first and is a model now followed by a number of others. It started life as a closed-ended fund, but then converted to a semi-open-ended structure running until 2036, with a redemption window every five years.
“Traditional closed-ended, limited partnership-type funds with a fixed investment period and fixed life remain extremely attractive for higher-risk investment approaches that seek to take advantage of a more defined opportunity. Institutional investors recognise that there is no one-size-fits-all answer for all types of real estate. Individual affordable homes are much more liquid assets than airports, and the key is matching the structure and operation of the vehicle to the characteristics of the underlying assets.”
Haynes: “The UK regulator should consider the example of the US, where open-ended ‘bricks and mortar’ property vehicles only allow redemptions monthly or quarterly, while daily-dealing open-ended mutual funds have strict limitations on illiquid holdings. The result: of the many thousands of US mutual funds in existence since 1972 only six have suspended redemptions, according to the Investment Company Institute. The UK cannot say the same.
“Germany has also taken action. The country’s open-ended property fund market experienced its own existential threat during the  global financial crisis, with many funds suspending redemptions. In fact, funds holding almost €20bn of real estate assets had to be wound down in the aftermath of the crisis. In response, the German authorities removed daily dealing and introduced a two-year initial holding period, with a one-year notice period for redemptions.
“However, investors in the UK do not need to wait for the FCA to act. A liquid solution for property investment is readily available in the form of listed real estate securities, which investors in most developed markets have embraced.”
Richards: “As part of the ongoing review by the Bank of England (BoE) and the FCA of open-ended funds, the BoE’s financial policy committee has established that there should be greater consistency between the liquidity of a fund’s assets and its redemption terms. AREF and its members look forward to working with the FCA and the BoE on this issue over the coming months.”
Are listed REITs a better solution?
Sayers: “REITs are a natural home for property assets. Their closed-ended structure means managers do not have to deal with inflows and outflows, meaning they are never forced buyers and sellers. REIT managers can take a long-term view of the portfolio and make decisions purely on the investment case. REITs’ closed-ended structure also frees them from the problem of cash drag that afflicts open-ended property funds, while their ability to gear can help deliver strong long-term performance as well as giving them the flexibility to take advantage of fast-moving opportunities.
“As REITs are companies listed on a stock exchange, investors are able to buy and sell shares whenever the market is open. During times of market stress, like those we have seen recently due to COVID-19, the share prices of REITs can suffer and investors who are selling at these times might not like the price. However, they are still able to trade, unlike investors in suspended funds. We believe that REITs’ closed-ended structure combined with a stock exchange listing providing liquidity is by far the best way to invest in property.”
Romano: “Depends. If the availability of immediate liquidity is a priority for an investor in real estate, then listed REITs could be a good solution. Also, as a way to gain immediate and diversified exposure to particular sectors and/or markets that are not easily available otherwise. The trade-off is a higher volatility and a higher correlation with public markets – often some of the risks investors are trying to avoid by diversifying into real estate in the first place.”
Barrie: “The debate between investing in a REIT versus an open-ended fund is not a binary one. The decision on whether to invest includes a number of factors, but the key consideration is a trade-off between liquidity and short-term volatility. Listed REITs are more volatile than unlisted funds but offer better liquidity. That said, the nature of the equity market means that price movements often happen quickly and by the time an investor wants to use that liquidity, the price has already been badly affected. As an example, at the onset of UK lockdown measures, the UK REITs price index was down 38% month on month, with most REITs trading at heavy discounts to NAV. In general, REITs and open-ended funds do not need to be either/or, but rather can be complementary in a balanced investment portfolio.”
Haynes: “While not all investment solutions are right for all investors, funds that invest in listed real estate securities may be a more appropriate vehicle for investors who want daily liquidity in real estate because these funds invest in assets that are securitised and trade intraday by design. As such, this allows funds that invest in REITs to offer daily liquidity without the need for large liquidity buffers. Daily liquidity can also give active fund managers the flexibility to quickly shift assets to geographies and property sectors they believe are most attractive. Moreover, the global REIT market offers a diverse source of investment opportunities.
“A feature of REITs and their intraday liquidity is that they can experience short-term volatility similar to other listed stocks, but that can provide active managers opportunities to exploit temporary mispricing in the market to generate alpha. For example, the recent decline in listed real estate share prices has resulted in net asset value (NAV) discounts not seen in years. Based on our marked-down estimates of private-market values, global REITs are trading at a 14% average discount, representing an attractive opportunity to consider listed and ride the wave of recovery.
“Additionally, it is worth noting that over time REITs have historically behaved more like private real estate, which makes sense since capital appreciation and dividends are tied directly to underlying property cash flows.”
Richards: “Like daily-traded retail property funds, listed REITs provide access to a diversified portfolio of commercial property. As listed equities, they are subject to the short-term swings in the equities market and in the short term they perform much more like other listed equities than the property market in which they invest. It is only over the medium to long term that they offer performance closer to the underlying property market.
“Whilst their listed nature provides the ability to trade their shares very quickly, this is at the cost of much greater short-term price volatility than for units in open-ended funds.”
Should institutional investors look to closed-ended vehicles instead, such as the recently proposed Professional Investor Fund (PIF)?
Sayers: “REITs’ closed-ended structure, stock-exchange listing and the extra layer of governance provided by an independent board make them an ideal structure for investing in illiquid assets like property. Any newly proposed fund structures – open or closed-ended, or a hybrid of both structures – should be measured against this established and effective solution.”
Romano: “Again, depends. An investor who does not need even the semi-liquidity provided by open-ended funds can benefit for the often higher total returns of closed-ended vehicles – for example, because exit decisions can be optimised. But a closed-ended fund does not eliminate the valuation issues affecting the market in the current crisis.”
Forbes: “The proposed PIF addresses a different issue, and is specifically not available to retail investors. For institutional investors, current UK regulation has resulted in hotchpotch of fund vehicles, none of which is particularly appealing for institutional investors investing in real estate. Many end up using offshore unit trusts. The PIF creates an onshore fund vehicle that is attractive for both closed-ended and open-ended funds for institutional investors.”
Barrie: “Again, it is important to understand that investors (across the retail and institutional sectors) have a range of different criteria for investment and we (as the provider of investable options) seek to offer a range of solutions that can meet these. As with REITs, the question of ‘closed-ended good, open-ended bad’ is too simplistic to capture all strategies. Closed-ended unlisted funds have many positive attributes and can offer secondary market liquidity, although this may be less certain and often outside of fund management control. They tend to have more of a ‘club’ feel, but offer limited investor controls and often include leverage. Open-ended funds have their benefits too, which are touched on above.
“As mentioned previously, there is always room for evolution in order to support the widest range of investment strategies whilst offering protection for investors. New fund type proposals (such as the PIF) are welcome, and a further step on the journey for property funds more generally.”
Richards: “The PIF is designed to fill a gap in the UK’s fund offering for professional investors relative to competing jurisdictions. UK fund managers are currently forced to consider other jurisdictions if they want to serve pension and other institutional investors with a closed-ended, unlisted, tax transparent fund structure with tradeable units which is not required to operate as an authorised fund for UK regulatory purposes. The UK does not offer such an vehicle and the PIF would fill this gap.”