As the last of the suspended U.K. property funds reopens, now is the time for investors to act to address the liquidity mismatch of using open-end vehicles to invest directly in illiquid bricks and mortar. We believe real estate securities are a better fit for open-end funds—not just for liquidity reasons, but for the ability to diversify beyond the U.K. property market.
- The lockups of U.K. direct property funds in 2008 and again in 2016 have exposed the design flaw of relying on cash buffers to provide liquidity in times of market stress.
- Rather than imposing larger buffers (and greater uninvested assets), investors should consider the well-established model of real estate ownership through REITs.
- While REITs are still relatively new to the U.K., the structure has already had a transformative influence on U.K. listed real estate, prompting a general shift to more stable, cash-flow focused business models.
- Funds that invest in global real estate securities can offer liquidity in the underlying assets, diversification outside of U.K. property markets and a track record of strong total returns.
Real estate funds have become enormously popular in the U.K., attracting investors with the prospect of high yields and strong returns. But in the turmoil that followed the Brexit vote, many open-end funds that invest directly in real estate were forced to halt trading or impose severe valuation adjustments, penalising investors looking to sell.
While many investors caught up in these funds have seen some relief with the gradual removal of trading restrictions, there are still questions about these funds’ future viability. Given the continued uncertainty about how the Brexit will be managed, we believe investors can no longer afford to turn a blind eye to the structural flaw of these vehicles—the inherent mismatch of trying to create daily liquidity in an investment vehicle when the underlying assets are illiquid, with the result that the ability to sell may at times become illusory and unreliable.
The recent misadventure also raises the question of whether it’s time for U.K. investors to seriously consider diversifying their real estate investments away from a purely domestic-focused strategy to a more pan-European or even global strategy. With U.K. property exposed to Brexit risks, investors have a strong reason for casting a wider net into other property markets.
Twice Bitten, Twice Shy
Liquidity is rarely an issue when times are good and the supply of capital is strong. But in stressed conditions, when there is a rush to exit, the liquidity buffers built into these funds may quickly become depleted, putting fund managers in the regrettable position of having to sell illiquid assets in a deeply unfavourable market. Investors must also consider the cost of maintaining these liquidity buffers—both in terms of lost performance potential due to the low returns on cash equivalents, and the fact that investors are paying fund managers to hold cash at the bank.
Following the collapse of the open-ended direct property fund sector in 2008, it seemed inconceivable that these funds would return to prominence. But with the collapse of Gilt yields and the recovery in real estate, they returned more popular than ever, lifted mainly by the hunt for yield. Now, following a second liquidity crisis in relatively short succession, we are hopeful that investors will learn from these episodes and ultimately follow the path of other developed investment markets in embracing global real estate securities as means of allocating to real estate.
Take Australia, for instance, which twice experienced its own issues with unlisted property trusts (UPTs), the country’s once popular version of open-ended direct property funds. First in the early 1990s and again during the 2008 financial crisis, UPTs suspended redemptions in the face of accelerating withdrawals, with freezes in 2008 affecting an equivalent of up to £11 billion.
After the first episode, fund managers attempted to address the liquidity issue. In recognition that open-ended funds may face issues if completely invested in unlisted property, they moved to allocate a portion of assets into cash or real estate investment trusts (REITs) to meet future redemptions—a step mirrored here in the U.K. But when liquidity buffers failed to provide protection in 2008, investors voted with their wallets and largely turned their back on the UPT market. In its place, Australians embraced the REIT market, which has experienced significant growth within the country over the last decade.
Real Estate Securities Funds: A Modern Alternative
Many U.K. investors are undereducated about listed real estate securities, which is understandable considering that the REIT structure is relatively new to the U.K., implemented in 2007 just as the global financial crisis was taking shape. Also, returns for listed U.K. real estate have been substandard over the long term. But there’s a deeper story.
Until REITs came onto the scene, listed U.K. real estate companies were strongly focused on developments and growing their net asset value, and less focused on securing and growing a cash flow stream. It was the opposite of the business model used by many of today’s REITs and generally resulted in a less-attractive return profile for most investors. With the implementation of the U.K. REIT regime in 2007, the listed property market has changed dramatically and 80% of the U.K.’s publicly traded real estate companies have converted to REITs.
REITs have been a game-changer for the global listed property market, providing a tax-efficient form of corporate real estate ownership. REITs typically do not incur corporate taxes as long as they meet certain requirements, such as paying out nearly all of their income to shareholders via dividends. This distribution requirement in particular has generally resulted in attractive, growing dividends. The spread of the REIT structure to nearly 30 countries over the past 20 years has led to significant growth in the global listed real estate market, now valued at nearly £1.5 trillion . This growth, along with the resiliency of the REIT market through the global financial crisis, contributed to the recent decision by MSCI and S&P to promote real estate to its own dedicated sector category in the major stock indexes—giving it the same prominence as technology, energy and financials.
We believe REITs and other real estate securities are a natural fit for open-ended vehicles:
- Underlying liquidity: REITs can typically be bought or sold at any time without forcing the companies to acquire or liquidate assets. REIT funds are therefore largely able to remain fully invested at all times, investing new monies with ease and raising cash quickly to meet redemptions, even under challenging market conditions. Because the underlying assets are liquid, REIT funds can typically offer daily liquidity to their investors. This means they tend to be ideally suited to retail and defined-contribution investors, as well as to managers of funds of funds and model portfolios who need to rebalance with frequency.
- Global market: The size and depth of the global REIT market, coupled with the divisibility of owning shares rather than a whole building, mean that funds investing in real estate securities can achieve much greater geographic and sector diversification than traditional direct property funds. Access to property markets with different return profiles and divergent economic and monetary cycles may be of particular benefit today as investors face Brexitinduced uncertainty in the U.K. domestic property market.
- Tactical opportunities: REITs present fund managers the opportunity to navigate through market cycles by making tactical calls on geographies and property sectors that would be impractical to execute in the private fund sector. After the Brexit vote, REIT fund managers were able to quickly adjust sector and regional allocations to take advantage of potential mispricings.
Funds investing in real estate securities can also offer attractive characteristics for investors:
- REITs are still real estate: REITs may trade similarly to other stocks over short time periods, but over full market cycles, their capital appreciation and dividends tend to be directly related to the cash flows of the underlying property holdings. In other words, over the long term, real estate exposure is the primary driver of REIT returns and volatility.
- Compelling historical returns: The global real estate securities market offers a history of strong returns relative to private real estate, coupled with attractive dividend yields, relatively low management fees compared with direct property funds and efficient cash management. Exhibit 2 shows the meaningful historical performance advantage of global real estate securities funds compared with direct U.K. property funds over the past decade.
For the second time in less than a decade, the U.K.’s openended direct property fund sector has revealed its fragility and caught many investors off guard. We believe it is time the asset management industry recognises the critical flaw of these vehicles and follows in the steps of other highly developed investment markets—Australia, the United States and Japan, to name a few—and embrace funds that invest in global or European REITs and other real estate securities.
These materials are provided for informational purposes only and reflect the views of Cohen & Steers, Inc. and sources believed by us to be reliable as of the date hereof. No representation or warranty is made concerning the accuracy of any data compiled herein, and there can be no guarantee that any forecast or opinion in these materials will be realized. This is not investment advice and may not be construed as sales or marketing material for any financial product or service sponsored or provided by Cohen & Steers, Inc. or any of its affiliates or agents.
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