Property fund investors face six-month notice periods

Published by The Financial Times, 7th August 2020

Investors in open-ended property funds could have to wait up to six months to sell down their investments, under regulatory proposals to tackle the “liquidity mismatch”.

This weeks’ proposals from the UK’s Financial Conduct Authority are the latest attempt to solve a problem property investors have been grappling with for years — reconciling the daily trading requirements of open-ended funds with illiquid property assets that are hard to sell quickly.

Currently, more than £12.5bn of investors’ cash is trapped inside property funds that were forced to suspend trading at the start of the pandemic in order to deal with mass redemptions. However, investors continue to be charged high fees on their frozen investments.

Experts said the consultation was long overdue, but feared the changes would only serve to drive investors further away from the sector.

What do these changes mean?

FCA rules already require property fund managers to consider suspending funds during times of extreme market volatility to avoid risking a “fire sale” of illiquid assets. From September, funds will also be required to stop trading if the value of more than 20 per cent of their portfolio cannot be assessed accurately.

Fund suspensions are intended to protect investors, but have become a fixture of economic downturns. The rush to withdraw has intensified as investors anticipate their funds will gate, and rush to access cash before the door swings shut. Furthermore, funds need to hold a lot of cash to meet redemptions, which eats into investment returns.

The FCA is now consulting on proposals including considering a requirement for investors in certain property funds to give notice of up to 180 days when they want to cash out. The consultation will run until November, with the new rules expected to apply from 2021.

In theory, notice periods would help manage investor expectations, giving fund managers plenty of time to sell property if they needed to, as well as allowing them to invest more of that spare cash. However, advisers fear the new rules risk putting investors off even further.

“If these rule changes are made then a lot of financial advisers will just stop recommending open-ended property funds to their private clients,” said Charles Incledon, client director at Bowmore Asset Management. “That will make it harder for those investors to diversify their portfolios.”

“Six months is a long time for any investment, and the price you get 180 days later could be materially different from the one you expected,” said Adrian Lowcock, head of personal investing at Willis Owen. On the other hand, he said, a six-month notice period would discourage short-term investors and potentially make the asset class less susceptible to sell-offs.

Notice periods are not a new concept. In Germany, property funds have a one-year notice period, and the sector is “flourishing”, said Ian Sayers, chief executive of the Association of Investment Companies, who said the UK should consider following Germany’s lead.

Should I even own property funds?

Advisers say commercial property has a place in the average investors’ portfolio, though it should be a small one. Many investment managers will recommend allocating no more than 5 per cent to property as an alternative investment, and stress that investors must be aware that property is a highly cyclical investment.

Introducing six-month notice periods may feel somewhat academic for investors’ whose cash has been trapped since April. In order for the gates to be lifted, property fund managers will need to see a return to normal activity — yet no one seems certain when that could be.

“Property funds have been really unpopular with investors for a while now,” said Laura Suter, personal finance analyst at AJ Bell, noting that investors were factoring in the likely impact of Brexit on rents and property values, not to mention the huge shift towards online shopping under the pandemic, which has weighed on retail property.

One of the biggest problems affecting the sector is how to value assets in a falling market. At the start of lockdown, physical property valuations were suspended due to social-distancing measures. These are now possible, but it is much harder to judge the long-term impact of trends like working from home on the value of city centre offices, or the effect of so many insolvencies in the retail and restaurant sector.

Investors keen on property will have to be selective in their fund choices, says Ms Suter. Compared with a fund holding retail and City offices, “a fund that held a lot of supermarket stores, DIY stores and distribution centres for online businesses would have performed much better during the current pandemic,” she said.

How else can investors gain property exposure?

In a separate report on Thursday, the Bank of England said that even with the implementation of redemption periods, “other structures, such as closed-ended funds, may be more appropriate” for investing in illiquid assets such as property.

It also announced its intention to address the “distortions” that discourage investors from buying closed-ended funds, noting these do not receive the same promotion as open-ended funds by asset managers or advisers.

“We question what investors have to gain by sacrificing daily liquidity, given that there is a good structure for investing in illiquid assets already in place — investment trusts,” said Dzmitry Lipski, head of funds research at Interactive Investor.

Real estate investment trusts (Reits) have a closed-ended structure, and their shares are traded on the stock market. Since April, although investors have been able to trade, share prices have plunged with many Reits trading at large discounts to net asset value.

Mr Lipski added, “No structure is perfect . . . we still prefer the closed-ended structure when it comes to less liquid assets.”

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