Looking at where pooled funds struggled in the crisis provides guidance on how they can be stronger in future. Bill Hughes draws some conclusions
The painful setback in the UK property markets over the past two years has produced incredibly challenging conditions and the pooled property fund industry has never been so fully stress tested.
Those conditions have also highlighted valuable lessons for the property industry. It is the duty of those managing, advising or investing in pooled property funds to respond constructively to events of the past 24 months, to ensure that the industry can be stronger for the future. There is no excuse for sweeping the deficiencies of the pooled property fund industry under the carpet, however tempting this may be now that the market has turned.
The commercial real estate market was one of the hardest hit by widespread global financial fragility and the contraction of credit. The scale and speed of the downturn was unprecedented, with property values falling in the UK by approximately 44% from its June 2007 market peak to its July 2009 trough (according to the IPD UK Monthly Index), with massive outward yield movements and occupational markets darkening before moving into reverse.
The impact on the pooled property fund industry should not be underestimated. Closed-ended funds with already high levels of gearing saw net asset values fall far more sharply than the underlying property market, putting pressure on banking covenants. Among open-ended funds faced with mounting queues of investors wishing to exit and a paucity of liquidity, many were forced into a position of suspending redemptions, thereby disappointing those who were aiming to turn property units into cash.
The UK pooled fund industry is more than 40 years old, dating back to 1967. Today, in total it has real scale and accounts for more than £25bn (€28.4bn) worth of unlisted funds. This represents around 10% of the investable commercial real estate market. But, within these aggregated numbers there is enormous diversity between funds, on dimensions as varied as expected unit liquidity, the use of debt or cash, sector/region focus and risk appetite. These differences have had a huge effect on individual fund reactions to the market conditions. Any effort to generalise is hazardous, but draw conclusions we must.
What has worked… and what has not?
Against this challenging market climate, many of the features of pooled funds which initially attracted investors have remained intact. It is worth a brief reminder of these key benefits, as a clue to how the future may unfold.
Three of the main reasons for investing in pooled property funds will endure. Firstly, pooled funds provide access to a greater selection of property assets. Secondly, they provide access to large lot size sectors, such as shopping centres, that would otherwise not be accessible to any but the largest investors.
Finally, these provide access to management expertise and in many cases sector specialism, where ungeared property outperformance has often been provided. The demand for these features will remain, and so the industry should expect to have a positive future, subject to dealing with some of the potential necessary improvements highlighted by the recent downturn.
Deficiencies have been apparent in funds where there has been an inadequate alignment between investors and their managers. Issues tend to have centred on weak investor influence, excessively manager-friendly fee structures, insufficient transparency, inappropriate use of debt, and poor explanation of liquidity mechanisms. Aggressive inflows stimulated by positive marketing could have been diluted through closer interaction between sales teams, fund managers and investment functions. Flows of money pouring into what is an inherently illiquid asset class could have been discouraged before the market reached its cyclical peak.
Open- and closed-ended funds
Open-ended fund structures should continue to play an important investment role in the future. In addition to the wider benefits mentioned above, these structures seek to provide a level of investment liquidity in response to demand. Through an enlightened and active management of fund liquidity positions, through braver anticipation of market conditions and a prior commitment to owning more liquid direct, listed assets and cash, it would have been possible to avoid the redemption suspensions put in place post 2007. Improvements can also be made to ensure fee structures and controls promote the right fund management behaviour, to ensure that mechanisms for closing funds are well understood and that there is an increased transparency in communication with investors, making them aware of fund manager activities and liquidity demands.
Similarly, the features of closed-ended funds need to be reassessed in particular to ensure that the type and volume of strategic debt implemented is appropriate. While high gearing levels are attractive in favourable market conditions, it is inevitably not a feature that should be increased towards the end of a cycle, particularly not through wholly inflexible arrangements. The market has been forced to remember that leverage brings with it risk alongside the potential for enhanced returns. This should be addressed by ensuring that managers produce, clear and well understood strategies for borrowing, in advance, placing sufficient emphasis on banking relationships and being transparent in all communication with both lenders and investors.
The global financial crisis was unexpected and painful. But by learning from the past two years, the pooled fund industry will be able to cope better with the lows as well as the highs of the cycle.
Bill Hughes is managing director of Legal & General Property and chairman of the Association of Real Estate Funds