Behind the building blocks of property funds

Annabel Brodie-Smith comments on the structure of open-ended and closed-ended property funds.

My sons are obsessed with the game, Minecraft, an online version of Lego (which they also like). For those not familiar with it, the aim of the game is to use blocks to build anything from a simple home to a grand castle and involves adventures with anything from spiders to zombies attacking your buildings. I was reminded of this game and importance of a sound structure on seeing the recent news about open-ended property funds.

These funds which mainly invest in commercial property have changed their pricing for sellers of these funds from the buying price to the selling price. This means that sellers of property funds are going to get 5% less than they would previously as there are now more sellers than buyers of these funds so the pricing has been changed to protect the interests of existing unit holders.

Demand for property funds has been affected by a number of headwinds including the EU referendum and changes to stamp duty for commercial property. Some property investment companies have also been affected by the change in demand, with discounts for the UK property sector widening from a 5% premium at the end of 2015 to currently a 3% discount, clearly having a tough short-term impact on their returns.

However, for long-term investors it’s questionable whether the open-ended structure works well for illiquid assets such as property. During the financial crisis when the commercial property sector plummeted a number of open-ended property funds were closed or semi-closed as managers struggled to keep up with the redemptions. Even in good times managers of open-ended property funds will need to retain a chunk of the fund in cash so they can meet redemptions. It’s inevitable that the managers will have to manage inflows of cash when property is fully priced and outflows when it’s out of favour, a headache which can impact on their performance. 

An investment company, with a closed-ended structure, is particularly suitable for an illiquid asset like property. Of course when sentiment changes investment companies’ share prices will suffer adversely but at least if you need to redeem your shares you can. You may not like the price but you can get out.

The closed-ended structure comes into its own over the long-term when investors can sit out the inevitable economic wobbles and their impact on the commercial property sector. Investment company managers do not have to worry about inflows of hot money and outflows when times are tough and buyers are hard to find but can concentrate solely on the long-term performance of the portfolio.

It seems an appropriate time to think about the suitability of the structure of property funds before the next downturn bites or, for those Minecraft fans, before the spiders attack!