In the last couple of weeks, the regulator has released the snappily titled, although aptly titled consultation paper “CP20/15 – Liquidity mismatch in authorised open-ended property funds.”
As is the case with all FCA papers I’ve read, there is generally a lot to read and digest and this one is no different. In the 70 odd pages of text within CP20/15 there are a lot of open-ended questions. I also felt there were contradictory points and parts of the system seemed to be completely overlooked which would have added value to the whole process. Although not a critique (I would not want to write a paper such as this as there is SO much to consider) here are some of my thoughts relating to property funds.
We have written previously about the mismatch between open-ended daily traded property funds and the fact that property cannot be daily traded, so there is no need to go over these point again (if you want to get our previous views, please ask and we’ll forward the previous observations) but we’ve had a little more time to process our thoughts since then and conversations have moved on.
Liquidity is a key reason why it makes it difficult for property funds to be in an open-ended structure. Simply put, you cannot buy and sell a physical building in the same manner you could a share in a company. It cannot be done electronically and instantaneously. Maybe when/if the blockchain gains popularity and acceptance then this could speed up the process somewhat, but there has to be a lot of water to pass under the bridge before this can become a reality. The cause for the most recent suspension of property funds though is not liquidity. Liquidity in this case refers to the liquidity of the individual fund, not of the market. A quick search through the paper and count refers to “liquidity” 135 times. “Material Uncertainty” – the reason why property funds are suspended this time only appears 4 times. Material uncertainty is when the whole of the property market cannot accurately price what is going on in the market as a whole. This is when surveyors are not willing to give a fair Net Asset Value of a building. This is price discovery of the worst possible kind. It makes sense when surveyors cannot price an asset to suspend all pricing. Stock markets do it fairly regularly. These are known as circuit breakers and happen much more regularly than you would imagine.
Liquidity refers to how much cash or cash equivalent assets a property fund has within their fund to meet the demands of investors should they wish to withdraw. Over the years this number has moved around a bit, but it is fairly safe to say somewhere between 5% and 25% has been the norm. In essence, a property fund is typically between 75% and 95% invested at all times. Even if the fund has the liquidity to meet redemption requests from clients, if material uncertainty exists, then the fund is suspended as this is the overriding factor.
If a fund is suspended, why can’t it still receive subscriptions? There might be people wanting to invest, and their investments can be used to offset withdrawal requests which provides liquidity and could mean properties might not have to be sold – or might not have to be sold at fire sale prices. Why are suspensions a two-way thing?
Why are open-ended property funds not allowed to borrow? Their closed-ended brethren can and do. This is not a gearing conversation, but a revolving credit facility situation where the property fund can use some borrowings - against a relatively sound asset after all – to meet the demands of the redemption request. The cost of the borrowing would be set against the investor wanting their money out. It happens elsewhere in the financial world. Take term deposits for instance. A saver puts £x into an account with 180 day lock-up but will suffer a withdrawal penalty should they need access sooner.
Why are property funds complex when it comes to pricing? There are still bid-offer spreads on some funds, single pricing on others, swinging single pricing on others still. For a universe with not many funds within it, this seems unusual. Personally, I think the market needs to collectively get together and agree a uniform pricing approach. I would like to know which route the regulator prefers and why. The middle office function of pricing property funds is not that simple and I would really like it to be widely known from a transparency perspective how the technical aspect fully works.
Technology has played a big part in the demise of the asset class too. With the advent of administrative platforms it has become very easy for both advisory and especially discretionary managers to switch in and out of funds very quickly with very little regard to the knock-on impacts. A couple of presses of buttons and hey presto – deal done (which could impact hundreds (if not more) of underlying client portfolios.
All investments should be considered long-term, but there will always be needs from investors to access their capital. If a client has a 20-year time horizon and withdraws on the 20th anniversary of the initial investment, but that anniversary aligns with a spike in prices, there is nothing the client can do about it, unfortunately, but the inference that insured products or pension investments are long-term investment and retail investors are short-term in nature is plainly not true. If retail investors in property funds have to have a 90- or 180-day redemption request, so should all other regulated forms of investing in the asset class.
There are lots of other things to talk about, but I do feel this is the start of the end of open-ended property funds in their current form, although this could take a long time. Property is a good asset class to invest in for the long run – it has portfolio diversification benefits from a performance and volatility perspective and arguably a nice yield compared to other assets. But, for property to thrive and survive not only does it need to adapt, but also the distribution and hosting channels need to change too. This needs the profession to pull together – lessons learned from this episode will help future issues – for instance, how liquid is the micro-cap market and what will happen during times of stress here? What is likely to happen to funds in other asset classes that are not actively traded? In some instances, illiquidity can be good. Let us not forget that. It is called an illiquidity premium for a reason.
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