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Consider the cost of UK commercial property

Concerns about commercial property have led some funds to adjust their pricing
March 7, 2019

Open-ended bricks-and-mortar property funds are cost-effective, simple to trade and have a low correlation with equity markets. But there is a fundamental problem with these funds - they aim to allow investors to buy and sell units in them on a daily basis but they hold physical commercial property which cannot be sold as quickly or in small chunks.

When investors want to withdraw their capital from an open-ended fund, providers must meet this request within days, but selling property can take months. Commercial property funds have large cash holdings to help facilitate this, but if investor withdrawals look as though they might amount to more than the funds' cash reserves, their managers may take measures to protect the funds and those still invested in them.

These include adjusting the unit prices or marking down the net asset value (NAV) based on a revaluation of the fund's assets, known as a fair value adjustment. These actions penalise investors taking their money out of the fund and, by effectively charging them to leave, shield investors who stay in the fund from higher costs.

The offer price is the price you pay to purchase a stock or a unit in a fund that has dual pricing, and the bid price is the price you accept when you sell. The offer price is generally higher than the bid price and the difference between the two is known as the bid/offer spread. The spread between the offer and bid prices of commercial property fund units reflects the cost of buying properties.

But funds can change the way they calculate the bid and offer prices if they are experiencing outflows. Funds normally operate on an offer basis, whereby the offer price is the unit price plus transaction costs of buying in, while the bid price does not include transaction costs so is lower.

But if the value of withdrawals from the fund is greater than the value of money coming in, and the fund doesn't have enough liquid assets to deal with them, it can move its pricing to a bid basis, whereby the bid price includes transaction costs. This is so that investors who stay in the fund do not have to finance the cost of selling properties to meet outflows and to discourage investors from withdrawing their money from the fund. 

 

Brexit effect

Continued Brexit uncertainty has had a detrimental effect on the outlook for UK commercial property. Investors began re-withdrawing assets from commercial property funds at an increased rate in 2018. Investment Association (IA) figures show a sharp rise in redemptions from UK Direct Property sector funds with net outflows of £336m in the last three months of 2018, and net inflows over the first nine months of that year of only £37m. This is far lower than the outflows of nearly £2bn from IA UK Direct Property sector funds in 2016, but any sharp rise in redemptions over a short period can stretch commercial property funds' cash holdings.

Some funds have taken steps to stem outflows. In December Threadneedle UK Property Trust (GB00BQ1YHW31) and Kames Property Income Fund (GB00BK6MJF73) switched their pricing from an offer to a bid basis, shaving around 6 per cent from the returns of investors withdrawing from them. And this year Janus Henderson UK Property Fund (GB00BP46GG64) has changed the way it calculates its bid/offer spread, increasing it from 0.25 per cent to 4.5 per cent. Janus Henderson said the new spread means those buying in and selling out of it now cover the costs of buying and selling properties, rather than investors who stay put. It also means the fund is less likely to have to move from offer to bid pricing, something it has done several times since 2016, reducing the returns of investors withdrawing from the fund by around 4.3 per cent. 

In the worst-case scenario, when commercial property funds do not have enough liquid assets to meet investor redemptions, they do not allow investors to take any of their money out of the fund for a period of time. It makes sense for a fund to stop trading to prevent it from having to sell properties at unfavourable prices to meet redemptions. This happened during the financial crisis in 2008 and after the vote to leave the European Union in 2016 when sentiment towards UK commercial property plummeted and led to a run on these funds. However, it means investors who want to come out of the fund at that time cannot. But in 2016 UK commercial property funds that had suspended trading resumed within six months.

 

More problems?

Alastair Sewell, senior director for funds at Fitch Ratings, believes there’s a growing risk that UK commercial property funds will have to stop investors withdrawing their money from them in the near future due to the high volume of redemptions. “There is potential for the market reaction to Brexit developments to be more severe than the reaction to the referendum result, particularly if there is a no-deal Brexit,” he suggests. “We doubt that the UK property fund sector could withstand severe redemption pressure without applying such measures. The gating of one fund could spark contagion to other funds if it disrupts market confidence.”

Meanwhile, the regulator - the Financial Conduct Authority (FCA) - has begun daily monitoring of open-ended property funds, according to the IC's sister publication the Financial Times.

“Cash levels are marginally better than in mid-2016," says Mr Sewell. "But we do not think liquidity is strong enough to prevent withdrawal restrictions."

The level of liquid assets in UK commercial property funds is generally better than in 2016 (see chart 1). But the FCA has suggested that commercial property funds should stop trading when there is considerable uncertainty over the value of their investments, meaning this becomes their first response rather than last resort. The FCA doesn't think that commercial property funds should hold cash because it can be a drag on returns and benefits the investors who are quickest to redeem - rather than those who remain invested in the funds.

Peter Toogood, chief investment officer at fund research company The Adviser Centre, supports taking steps to protect investors who remain in commercial property funds. “A fair value adjustment is exactly what equities do when there’s a change to sentiment, so why is this any different?” he says. “[And holding cash enables] fund managers to provide liquidity - they’re not doing anything wrong.”

However, Rory Maguire, managing director of rating agency Fundhouse, disagrees with holding illiquid assets in a daily-dealing fund. “The maths doesn’t work out and managing the administrative requirement of daily flows results in a compromised investment approach," he says. "But I don’t know what other choice these funds have. They have become very big because money has flown into them at a fast pace, but if the money leaves at the same pace as it came in it will be a problem."

 

Alternative options

Investors in funds that have moved to bid pricing need to consider whether selling out is worth the price. If there is a wobble in the UK commercial property market funds could mark down the value of their assets. But selling out of funds that have moved to bid pricing will incur a penalty.

The best strategy for investors in commercial property funds, whether they have adjusted their pricing or not, is to sit tight and wait until the funds and the sector reverts to normality. If you are invested in this asset you should in any case have a long-term investment horizon, because it is over such time periods that you are more likely to get better returns. 

If you are not willing to stay put but wish to retain exposure to UK commercial property you could consider real estate investment trusts (Reits) or commercial property investment trusts. Closed-end funds such as these are considered by some to be a better way to invest in illiquid assets.

If you want to redeem your holding in a closed-end fund such as an investment trust you cannot sell your holding back to the asset management company that runs it. Instead, you have to sell your shares to investors on the secondary market - just as you would trade other shares. This means there is not money constantly flowing in and out of investment trusts, so their managers do not have to try to manage this. They can buy and sell assets when they want to, and, if they choose, hold them for the long term. This enables them to ride out periods of volatility and they are not forced to sell assets at unfavourable prices to meet redemptions. They also don't need to have a cash reserve so can invest more of the trust's assets in the market, giving the potential for stronger long-term returns. 

And investors in listed funds can always try to sell their shares on the secondary market.

But because Reits and investment trusts are listed instruments they can be affected by equity market volatility. Their share prices can react quickly to changes in sentiment on UK commercial property. For example, in 2016, the Association of Investment Companies (AIC) Property Direct UK sector fell from a 0.79 per cent average discount to net asset value (NAV) at the end of May to 11.65 per cent by the end of June (see chart 2).

In December 2008 the sector weighted average discount for UK direct property investment trusts went as wide as 49 per cent, with some individual trusts on discounts in excess of 70 per cent, according to Winterflood. And last year, the sector went from a 0.16 per cent average discount at the end of August to a 7.86 per cent discount at the end of December.

You are always likely to be able to sell your shares in a listed property fund, but if you do this during a difficult period when their price has plunged relative to what you paid for them it could be at a massive loss. So you could lose out like investors selling units in open-ended property funds that have moved to bid pricing or implemented fair value adjustments.

And if you choose to wait for the share price to recover, you are in effect in no better position than an investor in an open-ended property fund that has suspended trading until market conditions improve and it can sell its assets at a good price to meet redemptions. 

But Mr Maguire maintains that closed-end funds are a better way to access commercial property. He argues that the infrequent pricing model used by open-ended funds means they falsely give the impression of steady value, whereas listed property funds' share prices reflect market sentiment. “We would rather see higher volatility that actually represents market behaviour,” he explains.

 

UK commercial property prospects

The primary consideration when deciding whether to invest in any kind of UK commercial property fund is the investment case for this asset. The outflows from open-ended commercial property funds and widening of discounts to NAV on closed-end ones are because investors are concerned about UK commercial property. This is particularly because of what the economic impact of a bad Brexit deal or no Brexit deal might be on the once lucrative office market. Changes to working life and patterns are also having a significant impact on the office market, particularly in the south-east of England where many commercial property funds and investment trusts have invested significant portions of their assets.

“The property managers we speak to are not that excited – especially about capital growth,” says Mr Toogood. “The yields on offer are not that compelling, you would want them to be closer to 5 per cent. For example, you could invest in the building HSBC (HSBA) is in and get a 2 per cent yield. Or you could buy HSBC shares and get a yield of around 6 per cent.”

Mr Maguire points out that private investors tend to forget or ignore their exposure to residential property, so when they add commercial property funds and trusts to their individual savings accounts (Isas) or self-invested personal pensions (Sipps), property becomes too large a weighting in their overall assets.

“Commercial property sits between bonds and equities - it offers yield with growth," he says. "Depending on where you are in your life cycle, equities can be a better diversifier. And there’s the high cost of buying and selling property because of stamp duty and agent’s fees. There should be a premium on property and you need to get it at a deeper discount to make it worthwhile. It must offer very appealing returns relative to other asset classes, and it currently does not."

 

Funds for exposure to commercial property

If you want exposure to commercial property but to avoid problems that could arise from Brexit Tritax EuroBox (EBOX) could be an option. It invests in logistics assets such as warehouses across continental Europe. It has a similar strategy to UK-focused Tritax Big Box Reit (BBOX). Tritax EuroBox launched in 2018 and has assets of around £295m, but has not started paying dividends. However, its managers are aiming to deliver a total return of 9 per cent a year over the medium term with a dividend of 4.75p.

Emma Bird, analyst at Winterflood, says: “The manager puts forward a convincing argument for structural change in occupier demand for continental European logistics assets and we would expect these to provide an attractive opportunity.”

Its share price was hit hard in the latter part of 2018 so it is on a discount to NAV of about 4 per cent. Its closest peer, Aberdeen Standard European Logistics Income (ASLI) Income is on a 4 per cent premium to NAV.

Another option could be a fund that invests in the shares of property companies rather than actual buildings. These real estate companies have the potential to provide both equity growth and income, but incur equity market volatility. BMO European Real Estate Securities Fund (IE00B5PZZD25) invests in stocks and Reits listed in the UK and Europe, and is run by Marcus Phayre-Mudge. He decides which sectors and markets to back via macroeconomic analysis, and also analyses the fundamentals of individual stocks. The fund has outperformed FTSE EPRA Nareit Developed Europe index over one, three and five years, and has an ongoing charge of 1.4 per cent due to a performance fee.

If you want to maintain exposure to UK commercial property and have a long enough investment horizon to sit out any problems, Kames Property Income Fund could be a good option. Unlike some of its peers it is not very focused on the south-east of England and high-end offices, and has an attractive yield of 5 per cent. It has moved to a bid pricing basis, so at the moment it is relatively cheaper to buy units in the fund. And when it moves back to offer pricing it will be relatively cheaper to sell out of the fund. 

Kames Property Income has been managed by David Wise since launch in 2014 and Richard Peacock since 2017, and has an ongoing charge of 0.87 per cent.

 

Fund/benchmark6-month total return (%)1-year total return (%)3-year cumulative total return (%)5-year cumulative total return (%)Ongoing charge (%)
Tritax Eurobox-10.93nananana
AIC Property Direct Europe sector average-3.44-7.8124.5217.41 
BMO European Real Estate Securities-8.554.7531.6969.211.4*
FTSE EPRA Nareit Developed Europe index-7.683.5825.6550.33 
IA Property Other sector average-0.217.1320.0640.68 
Kames Property Income-5.26-3.065.2 0.87*
IA UK Direct Property sector average0.833.7912.534.09 
Source: FE Analytics as at 01/03/2019, *fund providers.