Performance: Then and Now
Direct property funds are often sold as lower-risk investments that can produce strong appreciation and a high income stream. And until fairly recently, that was t
he case. Undersupply in the housing and commercial markets, coupled with low interest rates, fuelled much of the growth. However, the growth in rental income could not keep pace, which has caused yields to fall to record lows. This strongly suggests that property prices came too far too fast and that valuations are not sustainable. Moreover, the dearth of liquidity in credit markets and the higher interest-rate environment puts further pressure on property as it makes borrowing more expensive and makes other, higher-yielding opportunities more attractive.
The proof is in the recent shift in performance. The average U.K. bricks and mortar property fund in Morningstar’s database has gained 9.4% on an annualised basis over the past five years, while the FTSE All Share Index has returned and annualised 16% over the same period with more volatility. However, the funds’ fortunes have changed abruptly over the past six months. Funds available to UK investors that invest in shares of property companies have lost an average of 8.8% for the six months to 31 October 2007, while those funds investing in bricks and mortar stood up a little better; losing just 3.6%.
The Liquidity Issue
Flows into—and out of—the funds have, predictably, mirrored performance. In a clear sign of performance chasing, property funds attracted the most retail assets of any fund category over the past three years, according to the IMA. However, last month’s data from the IMA revealed that inflows had dried up and indeed there was a net outflow of £62m.
The problem for direct property funds is glaring: they invest almost exclusively in illiquid assets, and yet they must provide liquidity to their investors. This strikes us as a patently dangerous position to be in. One can already see the stress on the system. The units of the Norwich Property Trust were recently priced down by 4.72% in an attempt to keep outflows from forcing managers to sell property in a sliding market to meet redemptions. Furthermore, Schroders recently wiped off 12.5% of the value of its Exempt Property Unit Trust shares. M&G, meanwhile, has forced institutional investors to give 90 days’ notice of their redemptions. These tactics are designed to limit redemptions and (in the case of devaluations) to recognise the high cost to the fund if it is forced to sell properties.
The worst-case scenario is if investors in the funds decide they've had enough of the downturn and redemptions escalate. If property funds are forced to sell holdings into a declining market, it could accelerate the current downturn, and leave fund investors holding the bag. The end results could be sharp losses in investments that are thought of by many as being relatively safe and steady. This is not unprecedented: Liquidity risk is a concept familiar to any money manager worth his fee, and investors in direct property funds in Germany faced a similar situation in 2005--many funds had to devalue their holdings, and Allianz even bought a large amount of property from its German fund to allow the manager to raise cash.
Takeaways
It’s clear that market sentiment on property as an asset class has taken a u-turn and the short-term outlook is not positive. While we think there will always be a role for property in an investor’s portfolio, current events suggest their usefulness as high-yielding, low-risk offerings is misguided. They can live up to that billing for lengthy stretches of time, but when the property market starts to struggle, there is a high-risk of significant loss. Although the possibility may be small, investors in property funds need to realise that it does exist and assess their allocations accordingly. Moreover, for investors who already own a home or other property, it's difficult to make a strong case for adding more via a property fund. Whilst it is true that commercial property and residential property don't move in lock-step, the two are susceptible to some of the same key risk factors (interest rates among them, as we are seeing now), and you may not get as much diversification value as you think from commercial property.
