Is the writing on the wall for open-ended property funds?
There has been a tectonic shift in the UK's commercial property market in recent years, as large companies slashed office space and retailers pivoted to online. While the outbreak of coronavirus has proved to be a structural shock to the market, in some areas it has merely accelerated the pace of change. As soon as the prospect of a national lockdown was floated last year, a number of investment firms suspended their high-profile open-ended property funds, leading experts again to suggest time would soon be called on these funds. Many experts have insisted open-ended structures are unsuitable for commercial property  The recent news that Aviva and Aegon are winding down their property funds entirely may prove to be the final nail in the coffin. As the regulator clamps down on the vexed issue of liquidity, the future of commercial property investment in the UK will change and investors will want to consider their options. Open-ended funds have been a 'slow motion car crash'  Property assets have generally been considered a stable and relatively safe source of returns over the years, but experts have long been concerned about the liquidity mismatch in open-ended property funds offered by the likes of L&G and BMO. Liquidity is how easy it is to convert an asset into cash without affecting its price. A number of open-ended property funds offer investors daily or weekly liquidity, meaning they can withdraw cash quickly. However the underlying property assets are a lot less liquid and often take weeks or months to finalise a deal. The funds hold a portion of the portfolio - usually 20 per cent - in cash and liquid securities to mitigate this issue. The warning signs for property fund liquidity have been in the making for a number of years. In the wake of the Brexit referendum, a handful of property funds were forced to suspend redemptions as savers rushed to withdraw their cash. In 2019 the then Bank of England governor Mark Carney said: 'These funds are built on a lie which is that you can have daily liquidity for assets that fundamentally aren't liquid.' Since then open-ended property funds have had an increasingly turbulent time. M&G was the first domino to fall before anyone had even uttered the word Covid-19. As soon as lockdown hit, independent valuers were forced to introduce material uncertainty clauses which led to a slew of firms also gating their property funds. 'The issue with daily liquidity property funds has been somewhat of a slow motion car crash and unfortunately it will be some time yet before many investors are able to access the capital invested in these strategies,' James McManus, CIO of investment manager Nutmeg said. The success of the vaccine rollout and reopening of the economy have prompted leading investment managers to start to reopen their real estate funds. M&G reopened its property fund in April, saying that fund manager Justin Upton had sold or exchanged 38 properties for 702.7million while the fund was closed, reducing the total number to 54. And in response to liquidity concerns, M&G said it would allow actual property exposure to fall as low as 60 per cent in exceptional circumstances to help manage liquidity 'for example as a result of unusually high levels of investor redemptions'. Some firms do not want to take the risk. Last month Aegon announced plans to close its fund due to liquidity concerns, just a month after Aviva Investors did the same. Aegon suffered from office closures, with the fund having a near 25 per cent weighting towards non-London, south east offices, according to its figures in the Q1. Open-ended property funds have been under scrutiny from the Financial Conduct Authority in the wake of the mass fund closures last year. They have mulled introducing a notice period which would see investors have to wait six months until they get their money back. It has said it would help to reduce the risks to investors and the economy to sell assets quickly, rather than at the maximum price, to meet withdrawal requests. It is now waiting for feedback on a new structure - the long-term asset fund which was first outlined by the Investment Association in 2019. The LTAF will be an open-ended vehicle which would allow retail investors access to unlisted and illiuqid assets, including real estate and private investors. It is now consulting separately on the LTAF and in May said it will only confirm specific fund rules once the consultation is over. Aegon and Aviva's funds are valued at around 380m and 366m respectively, according to Morningstar data. They are dwarfed by the likes of L&G and M&G whose funds are valued at over 2bn, but it does suggest that even as the economy starts to recover the underlying issues remain. Indeed money continues to bleed out of the sector and between January and May of this year, property funds have suffered cumulative net outflows of 1.5bn according to data from funds network Calastone. And these outflows will likely continue until the regulator tries to address this liquidity mismatch. The Investment Association has previously blamed the failures of these types of funds on inadequate action by the regulator, which is in the midst of a consultation on a mandatory 180-day notice period for open-ended funds. This is unlikely to be well received by parts of the real estate industry but it is becoming increasingly difficult to think that these funds will be able to continue in their current form. However Oli Creasey, equity research analyst at Quilter Cheviot, thinks Aviva and Aegon will be the last of the funds to permanently close. 'You can't rule it out, but I'm not holding my breath for further casualties. The other funds out there are by and large bigger, which matters, and have been open for a while and so have probably already been hit by any panicked sellers.' Creasey thinks this is highly unlikely: 'The valuers would be less likely to do so because none of this is a massive surprise any more.' Instead the valuers may focus on individual assets or sectors, like retail and leisure, rather than a wholesale closure of all assets. 'It is an imperfect system,' Creasy conceded. 'You have properties that on a good day can take three months and you're expected to provide daily liquidity. We would prefer to ensure investors are properly educated to the risks.' For investors who want to avoid the risk attached with open-ended funds they can gain exposure to commercial property by investing in closed-ended structures like real estate investment trusts (REITs). The closed-ended structure does not have the same liquidity problem because the funds issue a limited number of shares, which are traded on the stock market. 'We've always preferred the closed-ended structure when it comes to investing in illiquid assets classes, like direct property,' said Moira O'Neill, head of personal finance at Interactive Investor. 'This structure isn't perfect, but it does meant that investors can head for the emergency exit if they need to. And, important but often overlooked - they can buy whenever they spot an opportunity.' REITs have performed relatively well in the past six months despite challenging conditions in the rental market. Warehouse REIT which focuses on urban warehouses is up nearly 26 per cent year-to-date. Urban Logistics and Tritax Big Box REIT specialise in logistics centres and have seen their share prices jump 10.1 per cent and 19.3 per cent respectively. They do not come without their difficulties however. REITs are traded on the stock market which means their value is based off their share price rather than the net asset value (NAV). It means investors could lose out during periods of market volatility. 'Investors get the benefit of liquidity given the equity nature of the investment, but the return streams do not necessarily resemble physical property, and yields tend to be much lower than those that can be achieved in the physical property market (although they are relatively stable)' McManus said. Creasy offers another alternative: 'One answer for investors is being aware the two vehicles exist. Neither is perfect and have different pros and cons. 'If you want to be buying property in a diversified way perhaps you can look at both of them in combination.' Exchange-traded funds are one way of diversifying exposure to UK retail and are a lower cost alternative. iShares UK Property UCITS ETF offers exposure to a range of UK-focused REITs and costs just 0.40 per cent a year. It currently yields 1.8 per cent. However it remains concentrated: of the 40 or so holdings, the top 10 account for 65 per cent of the fund's exposure, with Segro alone standing at nearly 21 per cent.