James Bevan: Property funds and their prospects

Property funds have hit the news after a number moved to halt redemptions. James Bevan looks at the underlying issues and prospects for the future.

The Brexit result was clearly not anticipated by market participants, and with significant uncertainty on the policy framework that lies ahead, a number of open ended funds have cut the value of their assets, and some have even moved to stop fund outflows.

There are two rather separate issues at stake. First, reduced predictability of the outlook for monetary and fiscal policy as well as investment and spending, does imply that investors reasonably require an increased risk premium, or yield, to participate in any ‘risky’ asset and income stream.

Increasing the required yield on a perpetual asset with an assumed underlying yield of 5.5% by 0.25% to compensate for the increased uncertainty implies a reduction in pricing of around 4.5%, even with no change to the reliability of the long term yield itself.

This is the sort of order of magnitude in value reduction made by many managers and funds, and looks proportionate in the current environment. It also happens to match broadly to the immediate price action seen in prior periods of profound uncertainty such as just after the Lehman debacle in 2009.

First principles

The second issue relates to preventing outflows. From first principles, a manager is required to ensure that an orderly market is maintained, and by limiting outflows, funds can allow the dust to settle and stop fire sales from triggering the collapse in values that many seem to fear.

Fears for the property outlook are signalled by the down move in the price of real estate equities, and especially reflect the perceived vulnerability of the London office market to a possible drop in demand, as global businesses consider re-locating activities to Ireland and mainland Europe.

There are two considerations in pricing a property. First there can be an assessment of a fair price, which is a property’s underlying and ongoing value, representing the capitalised value of future rental streams net of costs, assuming willing buyers and sellers.

But secondly there is the price at which a transaction will clear the market at any particular point in time, and where that price may reflect a ‘forced’ transaction where one of buyer and seller are not ‘willing’.

Thus a price may be squeezed to a fat premium to fair value where there is an eager buyer and a reluctant seller. Conversely, prices may fall significantly where there is a forced seller and absence of ready buyers. This is the case with all assets, but particularly so with real estate where each property is unique in terms of build, specification, condition, tenants and leases, and precise fixed location.

Prudent management

The decision by some property funds to suspend redemptions underscores the nature of property as a long-term investment, and limits the risk of forced selling of underlying properties in this period of uncertainty.

Stemming fire-sales whilst the fog clears on the UK’s future political and economic environment can be seen as prudent and responsible management.

As to what likely does lie ahead, Mr. Carney has reminded markets that the Bank of England will support liquidity and credit as required, and the drop in interest rate expectations seen since the Brexit vote counters rises in risk premia.

Meanwhile gilt yields look set to stay lower for longer, and low sovereign yields leave property rental stream likely more attractive than many of the alternatives, and boost demand of commercial property if it is confirmed that the risks of severe recession are overstated.

The weakness of the pound is a factor here, increasing the ‘cheapness’ of UK assets for international investors and businesses, and supporting the economy through enhanced translation of foreign earnings for the UK’s global businesses and helping exporters to be more competitive.

In terms of the underlying fundamentals, there are reasons to be sanguine about the prospects for occupier markets given the relative lack of supply which will part compensate for any reduction in demand. With specific reference to London, even in the event of a net loss of 70,000 jobs, the response by developers to weaker demand should mean that the vacancy rate rises only to around 8%, and that level can be seen as consistent with stable rents.

Clearly, the uncertainty created by the Brexit vote result has adversely affected sentiment, and this has driven outflows from property funds and assets over the last week or two. However, if occupier and investment markets come through this period of uncertainty as we expect, we can anticipate that fears of a repeat of 2009 are overdone.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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