A paper written by a financial stability expert at the European Central Bank (ECB) alongside colleagues has drawn attention to open ended real estate funds, in particular their exposure to liquidity risk when they offer frequent redemptions.
The paper by Pierce Daly and others entitled “The growing role of investment funds in euro area real estate markets: risks and policy considerations”, states the net asset value of real estate investment funds has more than trebled between Q4 of 2012 and Q4 2022 from €323 bn to over €1 trn.
With open ended funds accounting for 80% - or €835 bn of net asset value – the ECB research team said funds were primarily located in five countries. Those are Germany, Luxembourg, France, the Netherlands, and Italy, where most of the growth has taken place, but noted ‘extensive growth’ has happened in other countries.
The paper has been written against a background of a ‘sharp deterioration’ of the commercial real estate market, and concludes that real estate investment funds should be subject to a ‘common and comprehensive policy framework’ in order to ‘reduce the liquidity mismatch and risks to financial stability’.
It cites Blackstone in the US where the firm’s Blackstone Real Estate Income Trust (BREIT) recently experienced an increase in redemption requests, primarily from Asian investors. The ECB paper observed: ‘As a result, BREIT had to limit redemptions in line with its own withdrawal limits, undertake substantial property sales and source new investment to ease liquidity pressures.’
‘Similarly, in the United Kingdom many REIFs have imposed redemption gates following an increase in redemption requests triggered initially by the gilt turmoil and more recently by macro-financial uncertainty and the negative CRE market outlook.’
The paper continues by pointing out recent crunch points during covid, citing a finance research letter in 2022 suggesting open-ended real estate funds were more likely than other fund categories to suspend redemptions after the onset of the coronavirus pandemic.
‘This is largely because it is difficult to accurately value and sell illiquid property assets during stress periods, which may increase the likelihood of investor runs. Similarly, any deterioration in current CRE market conditions may also increase the potential for large redemption requests. If appropriate liquidity management tools (LMTs) are not in place, REIFs could have to resort to asset fire sales, thus amplifying market stress.’
The paper will make for uncomfortable reading for managers of open ended real estate funds given the asset class is being flagged for risk exposure.
The ECB paper says: ‘The importance of REIFs and their potential to amplify CRE market dynamics is particularly concerning in light of growing vulnerabilities in the CRE market itself.’
‘Euro area CRE markets have been subject to a series of major shocks over recent years. With the outbreak of the covid 19 pandemic, the office and retail segments were immediately and severely affected by lockdown policies.’
‘These parts of the CRE market remain subject to uncertainty over the effect of the resulting changes in behaviour, such as the shift towards hybrid working and e-commerce. While the market had shown signs of recovery in 2021 and early 2022, rapidly rising financing costs and wider macro-financial uncertainty now pose fresh challenges.’
‘In addition, strong price growth in the years leading up to the pandemic may have resulted in overvaluation in CRE markets, creating space for a large price correction in the event of adverse shocks. The severity of these shocks is clearly visible in survey data. These show unprecedented spikes in the percentage of investors reporting deteriorating financing conditions and a market downturn, along with a steady increase in the percentage of investors describing prices as expensive or very expensive.’
It continues: ’In the final quarters of 2022, risks associated with tighter financing conditions and macro-financial uncertainty began to materialise, with a sharp drop in transaction numbers and falling prices. Market activity – and by extension market liquidity – dropped sharply at the end of 2022, with 44% fewer transactions in the final quarter of that year than in the same quarter of 2021.’
‘Market intelligence attributes this to the wait-and-see approach adopted by investors in the face of uncertainty about future developments in financing conditions, inflation and the macro-financial environment. In addition, the literature indicates that transaction numbers can drop before a large market correction as buyers revise down their bid prices faster than sellers revise their asking prices.’
The paper continues by pointing out the structural vulnerability of open ended funds.
‘A key vulnerability in REIFs is the mismatch between the liquidity of fund assets and redemption terms. When redemption terms are shorter than the liquidation period of the fund’s portfolio assets, large and sudden investor redemptions can lead to tensions.’
It also suggests loans may exacerbate risks. ‘Leverage may further amplify vulnerabilities in the REIF sector and lead to spillover effects in other parts of the financial system. First, leverage implies greater sensitivity towards fluctuations in real estate prices. During market downturns, leverage therefore magnifies the losses faced by investors, which might exacerbate outflows and amplify vulnerabilities stemming from the liquidity transformation performed by REIFs. Second, the use of leverage creates links between REIFs and other financial institutions that act as credit providers. As a result, tensions in the REIF sector might spill over to other financial institutions, affecting the stability of the wider financial system.’
Policy options include addressing the structural vulnerability to manage spikes in liquidity demands.
The paper accurately notes that although real estate investment funds are regulated under the Alternative Investment Fund Directive (AIFMD), they may be subject to a range of national requirements that can go beyond the minimum standards of AIFMD. This, states the paper's authors, creates a need for 'consistency'.
All REIFs regulated under the AIFMD are required to have the ability to suspend redemptions when the fund is experiencing high levels of redemption requests. But the paper states: 'However, suspending redemptions is a blunt instrument that funds are often reluctant to use given the associated stigma and costs. Therefore, funds should also implement more targeted LMTs such as redemption fees and redemption gates. Making a broader liquidity management toolkit available to managers would enhance their ability to effectively manage the fund’s liquidity and thereby strengthen its resilience. The use of these tools should be guided by supervisors to ensure that it is consistent across funds, while there is a role for the European Securities and Markets Authorities (ESMA) in ensuring that the approach taken by supervisors is also consistent across countries.'
The ECB paper adds among other things: 'Policy measures worth exploring that focus on the liabilities side include lower redemption frequencies, longer notice and settlement periods, and longer minimum holding periods.'
