Investors are getting antsy about commercial property. As working and social habits are upended by COVID, businesses are reappraising how much office space they need, while shopping centres, cinemas, and restaurants and other food outlets have seen footfall drop from a continuous heavy drumming to a light patter.
On the other hand, investors with overweights to warehousing linked to online trade must be feeling quite pleased with themselves—as indicated by Ocado’s share price more or less doubling year to date.
There will be winners and losers in the commercial property stakes—but arguably more of the latter. Hence the nervousness, with many institutional investors appraising the size and nature of their real estate exposure.
Shedding Shoppers
Such ‘nature’ encompasses both the sectors towards which investments tilt, and through which vehicles. How you invest determines how easy it is to access your capital, should you need to. For example, the gating of direct property funds following the Brexit vote four years ago left “over £18bn frozen in the biggest seizing up of investment funds since the financial crisis”.
With the U.K. government intent on playing Mexican standoff over the latest negotiations, heightened anxiety among property investors is to be expected. Even for long-term investors, such as pension funds, it may no longer be a question of riding out the volatility, if what we’re experiencing represents a structural shift in real estate markets. Those mall shoppers may not be coming back in enough numbers—not now, not ever.
These anxieties feed into fund flows, where a sectoral split over the 12 months to August has been evident. The Investment Association has two property sectors: UK Direct Property—defined as those funds that invest an average of at least 70% of their assets directly in UK property over five-year rolling periods—and Property Other. The latter, as the name suggests, is much more of a mixed bag, investing in physical bricks and mortar, property companies, and REITs, nationally and internationally.
Liquid Flows
The five funds that have seen the greatest outflows over the year—losing a combined £407m—are all U.K. Direct. Conversely, the top four money takers, raking in £930m, are all Other. The top fund alone has attracted £759m.
The top three money takers all invest in global REITs and property companies, with strong skews to the U.S. market. The fourth-placed fund has a global remit, currently with about 70% in direct property. The fifth largest fund is U.K. Direct Property, but it’s a long way behind the first four. And, interestingly, its 12-month performance lags that of the biggest money losers.
Graph 1: One-year fund flows v returns to August 2020
Source: Refinitiv Lipper
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What’s driving this? It’s certainly not a simple matter of returns, as you can see from the graph. The relationship of returns to flows over the past year is clearly negative. The top money-taker has delivered negative returns of almost minus 21% over 12 months to August, where the fund that has lost most assets has seen relatively modest falls of minus 2.7%. Indeed, the average hit to performance of the five biggest money takers over the year was minus 14%, whereas the five biggest money losers returned an average minus 3.2%. At a sector level, U.K. Direct Property performance is down 6.3%, while Property Other has fallen by 11.1% over the period.
Hitting the Buffers
One explanation is that funds’ cash levels are an increasing concern. Because of the ‘lumpy’ nature of property trades, a direct property fund’s cash position can change significantly. If you’re buying or selling a shopping centre, it does make your cash weightings swing around rather a lot, as you can’t buy it one shop at a time. In August 2020, U.K. Direct Property funds had an average 12.5% in cash, whereas Property Other had a much more modest 3.8%. While the average total expense ratio for U.K. Direct Property is only about two-thirds that of Property Other (1.28% v 1.86%), investors still won’t want to be paying for that cash drag.
Cash weightings in U.K. Direct Property have also increased as a buffer against redemptions. Units in many direct property funds can be transacted daily. This can create difficulties during market stress, as the underlying assets are highly illiquid. As a result, suspensions have occurred with increasing frequency, such as in the aftermath of the Brexit referendum and in the current pandemic. This mismatch creates the need for large cash buffers. It’s not unusual for some property funds in times of stress to have 20%-plus in cash. But while you don’t need the cash when times are good, when things turn sour it’s never enough.
The Financial Conduct Authority (FCA) is reviewing this issue. For example, from 30 September, funds investing in illiquid assets such as property must suspend investment activities when there is material uncertainty over the valuation of more than 20% of their assets. In August, the regulator announced a consultation on whether to introduce a notice of up to 180 days for redemptions. The U.S., in contrast, limits the level of illiquid holdings permissible in a daily-dealing fund, and restricts redemptions on direct property to a monthly or quarterly basis.
In Germany, redemptions are only possible after a minimum holding period of 24 months has expired, and suspension through a lack of liquidity is 36 months. If this is insufficient, the investment manager loses the right to manage the fund. Such regulations mean that both countries have fewer blow ups. Successfully addressing this in the U.K. may see cash weightings drop and the sector regain favour, but it will still be some time coming.
Not Just for Christmas
That explains why U.K. Direct Property is unpopular. But why is Property Other doing so well, despite poor performance?
Many investors, whether because of asset allocation rules or simple preference, will need or want property exposure. The three main beneficiaries of inflows over the past year provide it in a highly liquid manner. Also, in a time of such manifold uncertainty, it allows investors to spread their bets globally. As seen from recent Lipper analysis, these eventful times have alerted U.K. investors to the attractions of foreign climes in other asset classes. In addition, they may feel that the pain endured now with the option of a speedy escape if things get really bad is better than being locked into a long and miserable relationship with an asset class with which you’ve fallen out of love.
Direct property, like a puppy, isn’t just for Christmas—you may be stuck with it for some time. Whereas, in pet terms, property shares are more like a goldfish: much less of a commitment.
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The views expressed are the views of the author and not necessarily those of Refinitiv. This material is provided as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice.
