Strategy & economics
The impact of uncertainty on property funds
What has happened?
A number of the UK retail property funds have suspended redemptions in their daily dealing funds.
Why have they done this?
Daily dealing property funds have a different liquidity profile to the physical assets in which they invest. They try to mitigate this by holding large cash balances, listed securities and properties which they believe they can sell in any environment. Since the UK’s EU referendum, the pace of outflows has increased; as a result, these funds believe that it is in the best interests of all clients to stop redemptions at this time and organise the sale of some underlying assets to raise cash before accepting redemptions again. While having a delay in receiving proceeds is frustrating, it could offer a better outcome, particularly for remaining investors, as it gives the funds more time to sell assets and reduce the need for a fire-sale of holdings.
How long will they be closed (or gated) for?
No timeline has been given, but in 2007/2008 funds were gated for between three and 12 months. Fund managers are obliged to review the situation every 28 days.
What have other funds done?
Almost all the daily dealing property funds have now suspended redemptions. The FCA has been aware of the potential liquidity problem and has been talking to all large property funds. Monthly and quarterly dealing property funds have generally not made any adjustments yet and thus far remain fairly sanguine about outflows. The advantage of having a fund which offers quarterly redemptions is that they have a far better chance of organising an orderly sale of assets to match redemptions. However, we would expect that this news will prompt further outflows across the sector. If they see an increase in redemptions they may also delay paying out proceeds.
Why are investors selling commercial property now?
Commercial property has had a couple of very good years in 2014 and 2015, which attracted a lot of money from investors seeking capital gains, however, the memories of 2007/2008 are still fresh and a lot of this money is now trying to leave. The sector was already seeing steady but manageable outflows at the start of 2016; this was prompted by profit taking and worries about a downturn in economic activity as well as the risk of Brexit.
What are the consequences of these funds gating?
These funds gating has attracted considerable attention from the media; this will likely lead to further outflows in the funds and sales in the listed sector. This is especially important for those funds which have to sell assets to meet redemptions. In normal circumstances, property values are determined by transaction values, however, there has been little transactional evidence since the referendum. As a result, values have become more subjective. Funds have moved to bid-pricing and some have also moved to fair value pricing as a contingency measure to better reflect current values. There is a danger that we will see a contagion effect, as funds are forced to sell assets to finance redemptions, which means that valuers will have transactional evidence pointing to lower property values, therefore reducing fund values, leading to further investor redemptions.
We are unlikely to see any significant markdowns in property funds’ 30th June net asset values, but 30th September values could be more vulnerable. In the short-term, values will likely be dictated by the number of forced sellers. However, we are in a very different position to 2007/2008.
Has the outlook for commercial property completely changed since we voted to leave the EU?
Commercial property is a cyclical business, capital values and rental growth are linked to GDP*. Some economists forecast that the chances of the UK moving into recession have increased since the vote to leave and there is a perception that businesses are less likely to want to expand or be willing to pay higher rents. Property is a business where sentiment can have a large impact and many pending transactions can come to an abrupt halt.
The chart below shows the correlation between GDP and total returns. If we enter a recession, capital values could be marked down further.
We felt that 2016 was going to be a year to collect income and grind out a small amount of capital growth through asset management and rental growth. The income side should remain steady, but asset management opportunities and rental growth will now diminish. However, it is important to remember the reasons for investing in property; the primary purpose being to generate income. The chart below shows the consistency of income, even in 2007 and 2008.
In a world of low growth and low interest rates, an investment which can generate a stable and relatively secure income will be attractive. The chart below highlights the relative attraction of property yields compared to government bonds. The data was produced in December 2015; since then the gap has widened as bond yields have fallen and property yields increased.
We do not think that we are about to see a downturn in commercial property as we did in the financial crisis for three reasons:
1) Valuations are not as stretched – during 2008 property traded on a discount to gilt yields and there were aspirational assumptions about capital growth.
2) There was a glut of debt-financed supply across the country; this time we have not had a development boom – although London supply is potentially more of an issue.
3) While some economists are forecasting that the UK will enter recession, it is unlikely to be as severe as 2008/2009.
Is now a good time to invest?
Investment trusts have moved far more quickly than funds, falling to significant discounts to their net asset values in the last couple of weeks. However, it is important to remember that these are historic values and these are likely to be marked down at the next valuation point. Yields of over 5% look attractive but the sustainability of these yields will be vital. Funds or investment trusts with longer lease profiles are likely to be less vulnerable. Those funds with fewer investments in the City of London and its periphery are also likely to do better.
We think it may be too early to start buying the listed sector, as net asset values will probably have to be downgraded. However, there will be an opportunity to gain access to a high and steady income as long as the UK’s vote to leave the EU does not push the UK into a prolonged recession.
*Gross Domestic Product (GDP) is the monetary value of goods and services produced by a specific country in a given time period; it is commonly used as an indicator of economic health.
This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.