Does property have a role in your client's portfolio?

Property investment trusts and open-ended funds have both come under pressure for different reasons.

Alternative property investment trusts, which invest in assets such as medical centres, are facing slow-burning problems of rising interest rates, which is causing many investors to ponder the cyclical nature of those investment vehicles.

M&G recently announced that it will wind down its open-ended property fund over the next 18 months, due to liquidity issues.

The alternative to these vehicles, owning property shares or owning physical property via an investment trust, presents additional dilemmas, as it means being further invested in equities, which potentially reduces the diversification effect of owning property assets. 

Rory Maguire, managing director at consultancy Fundhouse, says he had long been concerned about the problem of liquidity with open-ended property funds, that is, if the market turns and investors seek their cash back in great volumes, the fund will not be able to sell the physical property asset quickly enough to meet the redemption requests, and so will be suspended. 

We still think property is a great building block for portfolio construction.Benjamin Benson, AFH

This has happened in consecutive periods of market stress, including the immediate aftermath of the Brexit vote in 2016 and of the pandemic. 

Maguire’s view is that persistently low interest rates flattered the returns achieved by the open-ended funds in the decade after the financial crisis, and it was the attractiveness of those returns that he says caused many investors to overlook the liquidity issue.

He adds he is “not surprised” that such funds are starting to close now that both the liquidity issue has become obvious and higher interest rates have dented the return prospects for the asset class. 

Open-ended property funds, which invest in physical property, including the soon-to-closed M&G Property fund, typically keep a significant slug of the capital in cash or other liquid assets such as government bonds in order to provide liquidity for clients seeking an exit. 

Ben Yearsley, co-founder of Fairview Investments, says this means investors who place £100 in an open-ended physical property fund may only have around £70 invested in property, with the other £30 invested in cash or bonds, as the return from cash or bonds would be expected to be lower than that of property.

The ultimate return that can be achieved from an open-ended property fund is not completely reflective of the returns achievable from property as an asset class.

This 'cash drag' is designed to prevent situations whereby the funds are forced to suspend redemptions, but despite the cash holdings, many of the funds that hold the positions in cash, including the soon-to-close M&G fund, have also had to suspend dealing. 

Another issue, previously highlighted by FTAdviser, is the asset management companies charge the same fee to “manage” the cash in the portfolios as to manage the property. 

M&G has only now, 20 months after dealing in the fund was suspended, agreed to stop charging the management fee on cash, and has cut the management fee on the property assets by 30 per cent for the duration of the time until it actually closes. 

Yearsley says these outcomes demonstrate that open-ended funds are not suitable vehicles in which to own physical property. 

Simon King, chief investment officer at Vermeer Partners, says he avoids investing in open-ended property funds “like the plague” due to the liquidity issues highlighted above. 

He also says it was wrong of M&G to continue to charge a management fee on the fund between now and whenever it closes, but M&G says it will have to manage the portfolio until then.

Benjamin Benson is head of investment research at national advice firm AFH, which actually runs an open-ended property fund.

The fund is only available to clients who are advised by AFH, and Benson says this means the liquidity impacts are mitigated, because AFH can manage the level of exposure each client has to property themselves, because the money is only managed for their own advised clients.  

We only invest in trusts that hold direct property; property securities funds are too generalist and expensive.Simon King, Vermeer Partners

His reason for believing the best way to develop clients' exposure to physical property is via an open-ended fund is that he feels gaining the exposure via investment trusts or directly via property shares are not getting the diversification away from equities, which he feels is the point of having property in a portfolio.

Benson says: “We still think property is a great building block for portfolio construction, particularly direct. In the short term, listed property does not provide the diversification that an alternative asset class should.

"Equity beta and correlation mean it behaves much more like risk assets, where a directly invested fund provides stability, and more property-like behaviour.” 

This apparent correlation with equities happens when, for example, an investment trust is part of an index such as the FTSE 250, and when investors who own the FTSE 250 tracker fund sell it, the tracker then has to sell some of the property investment trust shares it owns, and that may push down the share price. 

That means, despite the investment trust owning property, that slug of a client’s portfolio is vulnerable to movements in equity markets, and not diversified away from this.

Risk weighted?   

King only allocates to listed property funds on liquidity grounds, but says: “We have most of our limited property exposure via investment trusts, which has been painful due to the level of discounts they currently trade at.

"The correlation to equities is somewhat coincidental, with the main problem being that the market now demands a bigger yield premium than it did on obviously much higher risk-free rates, that is, it needs 8 per cent, not 5 per cent.

"It then adds a 'nobody will ever go to an office building or shop again' additional discount. We believe discounts will narrow and [net asset values] will rise, particularly in the more attractive areas such as beds, sheds and meds. This will probably not occur until interest rates start coming down.

"We only invest in trusts that hold direct property; property securities funds are too generalist and expensive.”

Yearsley says that while the returns from property investment trusts are correlated with equity returns in the short-term, “over the long term, the returns are similar to those available in property, so the diversification element reasserts itself.”

David Thorpe is investment editor of FTAdviser