Open-ended structure for property funds under attack

Annabel Brodie-Smith explains what has happened to open-ended property funds and the benefits of investment companies for illiquid assets.

At the end of May I wrote a blog about my sons’ obsession with Minecraft, the online version of Lego, in reference to my concerns about open-ended property funds’ structure. For those (like me) 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. This now seems even more relevant, since commercial property has been a casualty of the Brexit decision. A number of open-ended commercial property funds are currently closed which means their investors cannot buy or sell them at time of writing. Or in Minecraft terms, the spiders have attacked the structure and it is definitely wobbling!

Of course property investment companies are not unscathed by the Brexit decision and have been affected by the change in sentiment, with discounts for the UK direct property sector widening from a 5% premium at the end of 2015 to currently a 10% discount, clearly having a tough short-term impact on their returns.

However, recent weeks demonstrate that, for long-term investors, the open-ended structure does not work well for illiquid assets such as property. This has happened before.  During the financial crisis the commercial property sector plummeted, and again 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, in contrast, 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, and they have done so recently.  But at least if you need to sell 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’s time to seriously think about the suitability of the open-ended structure for property funds, because as Minecraft fans know, those spiders like to attack the structure again and again!