Property funds have dominated the headlines over recent days as group after group have been forced to stem outflows from their ‘bricks and mortar’ portfolios thanks to Brexit-induced redemptions.
The bombed out asset class had been on a stellar run over previous years, with an improving UK economic backdrop, a constant reach for yield among investors and a need for genuine portfolio diversification boosting returns within the IA Property sector.
As such, money piled into property funds, with many portfolios seeing their AUMs more than double over the past three years.
However, following double-digit returns from many direct commercial property funds in 2014 and 2015, there were signs that investors were looking to bank profits earlier this year due to yield compression and uncertainty surrounding the EU referendum.
Indeed, data from the Investment Association showed that the property funds saw net retail outflows in each of the first five months of 2016 – a significant reversal in trend.
Monthly fund flows (in £m) into IA Property between March 2015 & March 2016
Source: The Investment Association
Unfortunately, the picture has only worsened in regard to bricks and mortar funds since the shock Brexit result of last month’s referendum.
Data suggests investors have decided to pull their cash out of the sector en masse since the Leave victory, which has created a major issue within the property sector given the clear liquidity mismatch: the idea that while investors can trade property funds daily, property transactions can take far longer to complete.
Managers of property funds attempt to nullify this potential risk by holding a significant proportion of their portfolios in cash (meaning they can meet redemptions easily without having to sell assets) – but the sheer scale of recent selling has clearly tested groups.
Over the past week or so, six IA Direct Commercial Property funds – Aviva Inv Property Trust, Canlife UK Property, Henderson UK Property, M&G Property, Standard Life UK Real Estate and Threadneedle UK Property – have suspended trading while the likes of Aberdeen and L&G (among others) have been forced to readjust the values of their underlying fund holdings to stem outflows.
Combined, those funds account for £17bn worth of investor assets, according to FE Analytics. FE data also shows this dynamic has had a profound effect on investors’ total returns this year, with the average IA Commercial Property fund down 4 per cent since May.
Performance of funds in 2016
Source: FE Analytics
With many investors in the space now unable to pull their money out (or if they can, have to take a significant hit to their capital), there is a huge degree of uncertainty surrounding the asset class.
Tilney Bestinvest’s Jason Hollands says the outlook is likely to remain unclear for some time to come, especially given the result of the EU referendum and the now fraught political backdrop in the UK.
“Actual commercial property transaction volumes could remain low for some months as deals go back to investment committees and businesses await greater line of sight on who will lead the negotiations between the UK and EU over Brexit and their opening stances,” Hollands (pictured) said. 
“While monetary policy and bank lending conditions remain very supportive, with ample supply of credit available (quite unlike 2008), fiscal measures to shore up business confidence are becoming increasingly urgent. Calls to slash corporation tax are gathering momentum, with the Chancellor lending his support to the idea but policy making seems to be in limbo because of the Conservative Party leadership election and a likely reconstitution of Cabinet responsibilities that will follow.”
“A speeding up of the Tory Party internal leadership process would be helpful.”
As such, Hollands warns investors in commercial property funds could well face a rough ride over the short to medium term.
“Given this impasse, it is going to be a waiting game that will require patience, so investors in suspended open-ended funds shouldn’t expect the gates to be reopened any time soon. Dealing in funds may well be suspended for three months, possibly for the remainder of the year,” he continued.
“The ingredients for an improvement in sentiment will be a stabilising of the UK political leadership, pro-growth fiscal measures to dovetail the already highly accommodative monetary policy that will lift business confidence from its current nadir and evidence that the weak pound is attracting renewed interest from overseas investors.”
While Hollands says funds could remain closed to trading for three months, Keenan Vyas – director at Duff & Phelps – warns that groups will come under pressure to re-open their funds by the FCA or underlying investors at some stage.
Unless the backdrop improves, Vyas warns the picture could deteriorate quickly.
“For retail funds in particular this presents a challenge as there is an expectation that investors can redeem at all times, as compared to certain institutional funds, which can include lock up periods. When this occurs there will be a need on the part of funds to balance managing liquidity and honouring the activities of investors,” Vyas said.
“If there continues to be a tremendous amount of redemption pressure in a short period of time this could result in a large number of sales transacting below book value and an eventual overall correction in property asset pricing across the UK market.”
“Fund managers will also have to consider what the sale of one asset below book value means for the rest of the portfolio, and how a second sale at an even bigger discount would reflect onto the remainder of the portfolio.”
Given recent developments, it isn’t surprising that many are comparing the current backdrop to the environment presented to investors during the global financial crisis.
During that time, the collapse of the property market meant many funds had to lock-in investors due to a lack of underlying liquidity which, in turn, meant the sector posted significant losses.
Performance of sector versus indices during the global financial crisis
Source: FE Analytics
Lee Goggin, founder of findawealthmanager.com, says many of those fears are justifiable.
“A lot of investors are being stung by the suspension of commercial property funds and imposition of swingeing barriers to exit. It hurts but for most people commercial property is part of a balanced portfolio,” Goggin said
Goggin’s major concern is if the problems facing the commercial property sector spills over to the residential sector.
“There’s a very real fear that Brexit will mean some of the biggest financial institutions moving jobs out of London, which could be the pin that pricks the London property bubble,” he said.
“That could be particularly painful for buy-to-let investors who very often have most of their assets tied up in bricks and mortar. For many years that’s been a pretty shrewd move with house prices soaring, especially in London, but next year buy-to-letters will no longer be able to claim tax relief on mortgage interest and lenders are tightening up affordability rules.”
“We’re already seeing some bigger buy-to-let owners quietly heading to the exit gate to de-risk and diversify. That could become a stampede and turn very nasty indeed."
On the other hand, many market commentators believe the recent selling and general sense of nervousness has been massively overdone.
The likes of Hargreaves Lansdown’s Laith Khalaf say, for example, that given there was no bubble in property prior to the EU referendum, most of the factors that have driven the asset class since 2013 are still in place.
Performance of sector versus indices since 2013
Source: FE Analytics
As such, he urges investors to remain calm.
“Open-ended funds investing in property clearly have limitations, but long term investors in any market should be willing to tolerate periods of weakness. Selling out when prices have fallen sharply is usually a bad idea, particularly if the decision is a knee-jerk reaction,” Khalaf said.
“The fundamental trends that led to the popularity of property as an asset class are still in place, with interest rates still low and gilt prices still high. Economic uncertainty casts a shadow over the sector for sure, but as yet we lack real data on what the full impact of Brexit will be.”
Taking it a step further, Charu Lahiri – investment manager at Heartwood – says investors cannot ignore the fact that property prices are now far cheaper than they were a few years ago.
She points out that property funds currently hold far higher levels of cash than they did during the run up to the global financial crisis and though she isn’t bullish on the asset class having reduced her exposure earlier in the year due to Heartwood’s belief that the rally was in its latter stages, Lahiri argues opportunities may well arise for investors looking for lowly-correlated assets compared to equities and bonds.
“UK property contends with a number of headwinds and we are actively searching out areas of opportunity in the context of market falls,” Lahiri said.
“In our view, it is still too early to assess the impact of Brexit on property prices, particularly as we have yet to see the impact on transaction activity following the referendum result. The market is trying to evaluate a fair price but until we see actual property deals being done, nothing is certain.”
“We remain cautious on UK property given recent developments, but also recognise that we are reaching more attractive levels that could present opportunities further out.”