choc-a-bloc with illiquid assets has long seemed a risky idea to us.
Background: The Rise and Fall of Property Funds
In the last two years UK commercial property funds have seen their assets under management more than double as investors chased the property boom*. Over this period we have also seen the number of property funds more than double as investment houses jumped on the bandwagon. As property prices increased so did the cash balances of property funds – they simply could not spend their burgeoning inflows fast enough, and cash positions, usually targeted at between five and 10% grew to over 20% in many cases.
It was clear that this sequence of events could not continue unchecked, and halfway through the year a confluence of events finally caused investors to sit up and take notice. The most striking statistic was the dramatic drop in yields that new property investments could now generate as price growth outpaced growth in rental incomes. Yields in fact fell to almost 2% below the cost of borrowing, and it became more lucrative to hold gilts than it did property. Problems within the credit markets, caused by the US subprime crisis, also meant that funding for real estate deals became harder to secure – and the Northern Rock situation brought the problems home to UK investors for the first time. These factors and more helped create a self fulfilling prophecy whereby investors, driven by the media and events across the water, began to panic. They began redeeming units which, due to the illiquid nature of direct property, caused a number of leading property managers to change the pricing basis applied to their fund in order to protect existing investors – hurting performance overnight.
Worse was however to follow, as stated price falls were initially synthetic, and a result of the fund moving to a bid or cancellation pricing basis. But next valuers started marking down the prices of underlying properties within the funds. Norwich Property Trust for example is down more than 17% year to date, and the New Star UK Property Fund has fallen nearly 20% in the last six months. As redemptions persist cash positions are now at worrying low levels, and in certain cases 90 day notice periods have been applied to redemptions.
| Fund | 1m | 3m | 6m | YTD | 1Yr | 3Yr | 5Yr | 10Yr |
|---|---|---|---|---|---|---|---|---|
| Norwich Property Trust Inc | -8.52 | -11.72 | -17.98 | -17.29 | -16.23 | 4.91 | 8.37 | 8.49 |
| New Star UK Property A Acc | -10.05 | -14.21 | -19.81 | -20.06 | -19.15 | 2.21 | 6.47 | - |
| M&G Property Portfolio A Inc | -12.96 | -14.08 | -11.24 | -8.44 | -8.03 | - | - | - |
| SWIP Property Trust Acc | -0.27 | -10.66 | -10.58 | -8.48 | -8.42 | 7.72 | - | - |
| Total Returns as of 17-12-07. Returns for periods longer than one year are annualised. | ||||||||
More Problems Ahead for Property Funds?
The illiquid nature of direct property investing means that if we were to see forced sales it could become extremely costly for investors. Property valuations themselves have always been fairly subjective, but if funds are forced into selling properties in order to meet redemptions they will be put to the test. It is highly likely that the majority of prices received today will be lower than they would have been six months ago. Moreover, if property market participants know funds are under pressure to sell, their ability to negotiate the best possible price on sales could well be constrained.
Given the limitations of the format, property managers are doing what they can to protect their funds. Shifts in pricing basis and redemption notices are ultimately in the interests of the long-term investor: After all, if a fund manager is forced to sell properties investors will suffer. Over the last couple of days we have also seen two of the leading property fund managers, Norwich Union and New Star, make the highly unusual move of committing to carry out and publish fortnightly (as oppose to monthly) valuations. The changes were in response to concern that fund valuations were failing to keep up with the underlying market and investors redeeming their units were being overpaid to the detriment of current holders. The move also confirms that property values are falling.
What Can Property Investors Do?
Property cycles are part of the natural order of things. The current downturn in commercial property prices is not a new phenomenon – most will remember the quite dramatic drops we saw in the late 80’s and early 90’s. The difference this time round though is that many investors have fallen into the trap of chasing performance and as a result have become overexposed.
In our view, investors who hold a small measure of property within a well diversified portfolio as part of a long-term allocation programme have little reason to panic--in the long-term (say, at least 10 years), property should be a sound investment. However, those who have loaded up on the asset class to speculate on near-term returns will want to revisit their reasons for doing so and make sure they still make sense. Given the state of credit markets and yields on UK commercial property, we suspect they do not.
* Source: The Association of Real Estate Funds Quarterly Statistics, 30 September 2007.
