The deleveraging of property funds has been advocated but it is difficult to achieve in practice. The benefits of gearing are clear but managers need to be more strategic and selective in its use, as Andrew Smith explains

A feature of the international property boom, now a fading memory, was the explosive growth in indirect property investment. Unlisted pooled property funds have taken an increasingly prominent share of institutional property investment portfolios, both large and small, since the mid-1990s.

The process was driven by a combination of strong demand for property investment for pricing reasons, appetite from smaller pension funds that had a limited capacity to own commercial property assets outright, and growing interest in cross-border investment with local management. The indirect property model addressed all of these requirements simultaneously.

The growth of many pooled funds was fuelled by the use of debt, enabling investors to benefit from a performance boost from leveraged capital growth on larger portfolios. Property income comfortably covered the cost of debt in most markets, and investors found the banks to be enthusiastic lenders.

In embracing indirect investment, and tempted by enhanced returns, many pension funds moved from an unleveraged position to one where gearing was permitted. This approach began to sow the seeds of its own destruction as money flowed into the sector, fuelling unsustainable capital growth, and forcing income yields to record lows in many markets, such that income no longer always covered interest cost. Perversely, therefore, later entrants to the market were reducing risk controls just at the point when the risks of a market ‘bubble' were intensifying.

As boom turned to slump, leverage became a burden rather than a benefit. As a result, most leveraged funds have markedly underperformed their corresponding direct property markets. The changed conditions have prompted a reassessment of investment processes and asset allocation generally. There has been a marked shift away from leveraged investments and debt instruments, and a significant reduction in risk appetite. This meant a retreat from investments in hedge funds, commercial mortgage-backed securities, corporate bonds and emerging markets. It has also dented the reputation of pooled property funds, and the fund of funds model.

The use of debt in property portfolios has some important strategic implications:

It increases portfolio volatility, magnifying both positive and negative returns. However, its effects have usually been beneficial, with values rising and income more than covering interest costs; Debt was generally accepted when its effect was to boost fund returns. Now the reverse is true, its effects have come under the spotlight; It enables larger portfolios to be acquired, which should offset the additional finance-induced volatility through greater asset-level diversification. If, however, it is used simply to buy larger assets, this effect will be limited; The effect of leverage is asymmetrical: interest charges offset the contribution of leverage to positive returns, but compound the damage when returns are negative (see graph bellow); Fund life may be too short to allow the positive and negative contributions to performance to neutralise over the cycle if it includes a downturn.

Falling asset values have left many property loans in breach of loan-to-value covenants, while caps on the use of leverage in the constitution of many property funds have been challenged or exceeded. This has already caused some spectacular write-downs in fund net asset values, and fund insolvencies, particularly in the UK, where market returns dipped to an unprecedented low in 2008.

The problem is now transferring to other markets, which will see the worst point in the performance cycle this year. However, lenders are mindful of the risk of triggering asset sales at the bottom of the market. Often, these funds still generate enough income to cover interest payments easily. Where this is the case, banks are tending to take a longer view, supporting managers' efforts to weather the crisis.

It is clear with hindsight that more could have been done to reduce leverage in property funds in the earlier stages of the downturn. Nevertheless, this is very hard to achieve. There are four options:

Selling assets, but buyers are in short supply; Refinancing, but banks have little appetite for property lending, and high margins make it costly; Raising new equity, but there has been a dearth of buyers, who are reluctant to commit while asset values are still falling, and are themselves starved
of finance; Suspension of dividends, but this is unpopularwith investors, who see steady income as a key reason for investing in property. Furthermore, dividends are too low to make much impact if significant changes are needed.

As markets stabilise and the re-pricing runs its course, the time for de-leveraging will pass. When capital growth reasserts itself, the use of debt will help to recoup recent losses, and there is a risk that some managers will be caught similarly off-guard, still fighting yesterday's battle as values recover.

The severity of the downturn during the past two years has tested and challenged many assumptions about the construction of investment portfolios, for property and for other asset classes. Indirect investment returns have fallen well below those for direct property, and many investors have found themselves locked into crisis-ridden funds, unable to reduce exposure to assets previously seen as long-term holdings. This poses the difficult question of whether the non-listed fund investment model is fundamentally flawed. How can the model which was supposed to promote diversification and risk reduction have so magnified the dip in returns and the freeze in market liquidity?

In practice, the arguments for indirect investment remain as valid in today's downturn as they were in the boom times. Investors with limited resources have access to portfolios of a size, quality and geographical spread that would not be available through other means.

Nevertheless, the priorities of investors have shifted. In future, they are likely to require managers to use debt more selectively and strategically, with less reliance on ‘financial engineering' to generate returns, and fee structures aligned with this shift in mindset.
The challenge for fund managers is to bring forward a range of such products. If this can be achieved, the painful lessons of recent history will not have been in vain.

Andrew Smith is CIO and head of fund management at Aberdeen Property Investors