Investors’ thirst for liquidity is nothing new. In John Maynard Keynes’ Theory of Employment, Interest and Money, he bemoans the consequences of markets organised with a view to ‘so-called liquidity’. The particular nature of open-ended property fund investment warrants consideration through this lens.
The daily revaluation of liquid markets, Keynes writes, inevitably affects the behaviour of investors. ‘For there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project… if it can be floated off [into the markets] at an immediate profit.’
Professional investors are incentivised to exploit liquidity to generate short term gains. Keynes explained it this way ‘for it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.’ There are perhaps few better examples of the institutionalisation of the incentive, to impose liquidity on illiquid assets, than open-ended ‘bricks and mortar’ property funds.
UK open-ended commercial property fund managers tread a challenging path, between maximising the exposure of the fund to attractive illiquid property and the need to accommodate the liquidity requirements of investors.
A property asset is not commoditised, not easily exchangeable or divisible, but is unique and requires maintenance and management. But via the open-ended structure, the end investor has the right to trade without notice for immediate settlement. This permits open-ended funds only a tense and often unsatisfactory engagement with the asset class (one of the reasons Morningstar analysts do not assign ratings for these funds).
Properties take time to transact, yet the market may flood with liquidity, as investor flows respond reflexively to price changes. The pace of inflows often exceeds that which managers can prudently invest. In this scenario cash balances can quickly balloon, preventing the end investors from enjoying the yield the market promises (the IPD Property Index includes no cash, nor transaction costs). In response, managers clamour to invest even as the ‘probable yield’ falls.
When Property Investment Goes Wrong
The long lead times and credit dependence of developers drive a second supply cycle in reference to occupier demand and rental growth. These interactions can result in painful supply overhangs as witnessed in the late Eighties, when overdevelopment in response to a bubble in rents collapsed dramatically in the recession of 1990.
A fund’s situation may precariously reverse if markets turn. Call for disinvestments, outpacing the achievable rate of realisations, may drive - at this nexus of the liquid and illiquid - sustained demand/supply imbalances impacting value as assets must be fire-sold into unreceptive markets. This in turn creates a reflexive response as investors lose confidence.
In the worst case scenario, the veil of liquidity drops and investors may find themselves locked-in to protect the interests of those who remain. A recent example was the Brandeaux range of funds - suspended in 2013 when unable to accommodate redemptions. At the point of suspension, some redeeming investors had already waited two years.
Investors and managers must remain highly cognisant of the implications of the tension implicit in the open-ended structure for the asset class.
Against this backdrop, successful managers have needed to differentiate themselves through prudent, creative solutions to this tension. One strategy has been to exploit the other key idiosyncrasy of property investing – the managers’ scope to actively develop, manage and transform the assets they acquire and drive yields.
This may include full-scale development though this is a different risk proposition, not widely undertaken, merging or splitting properties, refurbishment or conversion to differing use. For example, recent deregulation has allowed a number of managers, such as Mike Barrie at L&G Property, to undertake transactions with a view to converting London offices to residential space, thereby capturing the higher yields available in this capacity constrained area.
How Fund Managers Balance Risk with Reward
In general, funds have adopted neutral cash levels around 10% to manage flows. Although in periods of positive sentiment new capital can frequently push cash towards double this, causing significant drag. Despite this, certain funds, such as Fiona Rowley’s M&G Property regard cash as the only reliable source of liquidity, and concern themselves solely with maintaining investment discipline as they put cash to work.
Others attempt to avoid the dilemma of cash drag and the pressure to invest by seeking alternative property-related assets with better liquidity. For example Gerry Ferguson’s SWIP Property Trust holds property derivatives, shares and even debt. Such investments may be useful but each has idiosyncratic risks and returns that can differ markedly from the real property holdings.
Size is a key factor that investors should consider. The larger the fund, the larger any cash buffer should be in relation to the likely outflows of any single investor. This also provides a second benefit – the ability to buy larger lot sizes.
Large funds can access prime properties - those ‘trophy’ assets in the best locations that tend to attract the best tenants, or replacements for any departing - which can provide additional security to the income stream. In extremis, these assets most likely find willing buyers quickly and thus provide liquidity.
Evidence for this view is provided by the crisis of 2008 when prime assets held value compared to secondary. They also recovered first, and even at current highs have enjoyed continued support from overseas investors who view the UK as a safe haven with strong legal backing.
This article was written for Professional Adviser magazine
