Why investors should be wary of open-ended property funds

Open-ended property funds have barred investors from accessing their cash in the past and will likely do so again in the event of a no-deal Brexit.

Open-ended commercial property funds may soon enter the spotlight once again, depending on how Brexit developments unfold over the next couple of weeks.

In short, a no-deal Brexit, the most negative outcome from the financial markets' perspective, will unnerve investors; of the main asset classes property looks the most vulnerable, amid fears that UK house prices will fall from their lofty heights after a two-decade property boom, particularly in London and the South East.

Investors hate uncertainty, so it will not come as a surprise if in the coming weeks and months open-ended property funds once again put measures in place that stop investors from accessing their cash. This point was made last week by Fitch Ratings, a research firm.

While investors are often told that 'past performance is no guide to the future', when it comes to commercial property funds invested directly in real estate there are sound reasons why history will keep repeating itself.

In normal market conditions, although it takes months for these funds to buy and sell the shops, offices and factories that are held in the portfolios, it is not a problem for investors to withdraw their cash on a daily basis, as a portion of the portfolio remains in cash.

But, during times of heavy selling, it is a different story as the cash buffer is depleted, which in turn makes it difficult for open-ended commercial property funds to meet withdrawals on a day-to-day basis. This is because property sales are not quickly or easily arranged, particularly in times of market uncertainty. It is therefore very difficult to raise money quickly.

Therefore, in order to halt the outflows and avoid firesales of assets, which would negatively impact investors who remain, fund management firms move to temporarily restrict or bar investors from accessing their cash. The global financial crisis and the Brexit vote in June 2016 were two occasions when this occurred.

In the case of the latter, over half the value of the £25 billion Investment Association property sector was frozen a week or so after the Brexit vote was announced. Suspensions, though, did not remain in place for long, with most funds moving to re-open the funds a couple of months later, as investor confidence returned.

The lesson that investors should take away is that the threat of a liquidity crisis is an ongoing problem for the open-ended property sector, even though cash levels have been raised. Since the Brexit vote, funds have moved to raise cash levels from 10% to 15% previously to around the 20% mark now, but in the event of investors exiting en masse it is likely that history will repeat itself.

Fitch agrees, noting that liquidity will not be strong enough to prevent fund managers from putting in place withdrawal restrictions, such as fund suspensions or mark-downs in the value of properties that they own, in order to deter investors from selling.

 "Open-ended property funds have a history of imposing extraordinary liquidity management tools such as gating to prohibit withdrawals, and we doubt that the UK property fund sector could withstand severe redemption pressure without applying such measures," says Fitch.

"Funds are unlikely to be able to meet a potential surge in redemptions by selling assets, given the illiquidity of commercial property. Initially, funds with weaker liquidity would be more likely to have to implement a gate, but the gating of one fund could spark contagion to other funds if it disrupts market confidence."  

Another lesson that investors should heed is that investment trusts, due to their closed-ended structure, are not under the same pressure to react defensively when investors take fright. Trusts have a fixed level of capital, so they do not need to sell the properties they own.

Instead, investors who wish to sell simply dispose of their shares, although this may be at a lower level than desired if there is a rush to the exits.

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