The Threadneedle Property fund resumed trading at midday on September 26. A number of the other large funds have also announced their intention to re-open in October, including Standard Life and Henderson. These are positive signs indeed and while the outlook for the asset class remains clouded, we are witnessing a return to normality as fair-value adjustments are reduced.
With general scepticism surrounding the future potential return for the asset class post-Brexit combined with an opportunity to trade out of these assets, we investigate what this might mean for investors. We assess the situation for those that already hold UK property funds as well as for those who might want to consider these products going forward. In doing so, we consider two key issues: does the asset class offer good value and is the structure appropriate for use by investors.
Property Fell Post Brexit
Property markets are one of the most broadly discussed topics in the investing public and with most people owning their own home it only increases the public’s interest in the topic. Broadly, there are only a few viable methods to invest in property, including directly – typically residential houses, through real estate investment trusts (REIT’s) or open-ended investment vehicles, managed funds with daily liquidity.
In the long-term, all property exposures should exhibit similar return profiles, however the various products associated with property can take very different paths over shorter time periods due to structural considerations.
Expecting all UK property vehicles to produce a similar result over shorter time periods would be a gross misunderstanding of the characteristics and fundamental drivers of each property investment vehicle. Underpinning each offering is a vastly different composition of assets, cash-flow requirements and debt levels that would lead us to think the recent historical pattern is likely to be driven by macroeconomic factors; namely low interest rates and the credit growth cycle driven by quantitative easing.
For instance, commercial and residential property has been loosely correlated over time, however the future could be materially different if the UK loses its passport rights as one could rationally expect increased risk in commercial properties, especially those in London that house financial institutions. There are also the underlying debt issues for REIT’s, which unlike UK open-ended vehicles, can carry significant debt burdens.
Real Estate Investment Trusts
This debt tends to magnify the impact of movements in property prices on the value of the funds. The UK’s biggest REIT’s are good examples of this with Land Securities Group (LAND) and British Land Company (BLND) carrying debt to equity levels of 24.6% and 41.6% respectively. However, it is worth noting that while these debt levels are substantial, they have significantly reduced since the unfolding of the 2008 financial crisis.
And then we have the state of yields. In a historically income-friendly asset class, we have witnessed a gradual decline in the attractiveness of the cash-flow from commercial property. Having reached levels as high as 6%+ in the aftermath of the 2008 financial crisis yields on REITS have fallen to today’s level of 2.5%. Similarly, a central London two or three-bedroom apartment is yielding approximately 2.9%-3.7%. Open-ended funds are offering marginally higher yields, but still generally in the 3%-3.5% region depending on the investment in question.
These low yields highlight a valuation problem as none of the above look particularly attractive relative to historical norms, especially in the context that the net amount of rent owners receive also need to account for property management and maintenance costs. Therefore, while the gross yield may remain attractive relative to cash or fixed income, the income an investor receives is significantly less so.
So What Should You Do? Buy, Sell or Hold?
Given these low starting yields, it is becoming increasingly difficult to justify the continued strength of UK property in a post-Brexit world. On almost all metrics, whether assessed against GDP, household income, yield, or otherwise, the market appears on the higher side of fair value in absolute terms plus the risk underpinning Brexit leaves a bleak risk-adjusted backdrop.
In addition to the low valuation-implied returns, we are then faced with the idiosyncratic nature of the investment vehicles that hold property.
The problem for UK commercial property as an asset class is that while the underlying value of properties can be expected to be reasonably stable, fund flow changes can affect unit price swings which has been exacerbated by the recent stamp duty changes. This creates a distortion to the underlying net asset value (NAV) for investors, even if the composition of underlying property fund remains in good shape.
Morningstar, with its strong heritage in fund research, regard the liquidity mismatch between an open-ended daily dealing structure and illiquid assets such as property as a serious consideration, however with a very long time horizon it is unlikely to cause a permanent loss of capital as the unit price is ultimately dependant on the value of the underlying properties, assuming the fund isn’t forced to sell assets at a substantial discount and you have the patience to hold.
Liquidity Remains an Issue
Despite this, a liquidity mismatch can be very uncomfortable for investors accustomed to the daily liquidity. This was evident in the immediate aftermath of the Brexit referendum. While we believe that fund managers behaved responsibly in suspending funds, the consequences of not being able to access capital is an important consideration when making an investment in property.
This remains the biggest issue at the current time and the primary purpose of this article. With fair-value adjustments gradually being unwound, they were as high as double-digits in some cases, the question becomes whether to sell at current prices or to hold for the yield. Our response would be that it depends upon the time horizon and objective of an investor. An income focused investor with the ability to lock money away may still benefit from the exposure provided by an open-ended property fund, whereas these vehicles are far less attractive for an investor who needs access to their capital and is seeking to maximise their total return.
While property is likely to remain in the spotlight for some time, the illiquidity challenges we have seen in this area are a timely reminder that anyone holding open-ended funds with illiquid assets, or potentially illiquid assets, such as high yielding fixed income, also need to balance their desire for a competitive income with the potential need to access their capital.
In conclusion, we believe that while the structural illiquidity issues of open-ended property funds are unlikely to lead to their demise, greater scrutiny by the FCA will probably result in them becoming more difficult to use as investment vehicles for retail investors. Consequently, we expect greater use of REIT’s and funds that invest in REIT’s as a way of gaining exposure to commercial property. This in turn is likely to increase the price volatility of property in portfolios and make property exposure less attractive for income investors and those governed by volatility targets.
