Commercial property has been marketed as an asset class with an attractive yield, low volatility and low correlation to other asset classes. It has, however, always suffered from a key risk – commercial buildings are valuable and unique, making them slow and costly to buy and sell and hence subject to liquidity risk.
Commercial property funds were a financial innovation that aimed to solve this risk by allowing investors to easily and, relatively cheaply, trade units in pooled vehicles investing directly in several commercial properties. This financial innovation has proved popular with retail investors and advisers, but like most financial innovations has in large part served to hide rather than reduce risk.
Hidden liquidity risk was most recently revealed just after the EU referendum vote when UK property funds from Aberdeen, Canada Life, Aviva Investors, Columbia Threadneedle, Henderson, M&G and Standard Life all suspended trading in their property funds.
Whilst these funds have reopened, there is now greater scrutiny of the sector, with the Financial Conduct Authority (FCA) launching a discussion paper into open-ended property funds in February.
So, liquidity risk is now firmly back in focus to the benefit of end investors and advisers who should be better able to evaluate the attractiveness of the sector. Investors and advisers should, however, note some other troubling aspects of these funds – they are very expensive too!
Quoted fund Ongoing Charges Figures (OCFs) don’t include additional high costs to buy and sell properties, property management fees or, when buying and selling units, bid/offer spreads or swing prices. High cash holdings (at 15%-30% currently-elevated post the Brexit vote) provide an additional drag. Vanguard estimated in 2015 that the median UK property fund underperformed the UK benchmark IPD Index by 3% p.a. over the previous 10 years. This is perhaps why these funds tend to benchmark themselves to peers on their factsheets, rather than the IPD or any other Index.
Investors should note that commercial properties are subject to appraisal-based valuation whereby their values are appraised by experts once or twice a year and actual prices, established through the process of sales, are far less frequent. Why this matters is that it has the effect of reducing apparent volatilities and correlations to other asset classes, making the asset class appear more attractive than it really is. Measured over longer intervals, property begins to look more like equity than bonds. This is perhaps best illustrated by the 33% fall of the CBRE UK Commercial Property Index post the 2008/2009 financial crisis, against a 37% fall in global equities as measured by the MSCI ACWI Index and a 10% rise in global bonds as measure by the Barclays Global Aggregate Index (hedged to Sterling).
Property is a valid and useful asset class – but investors and advisers would do well to think carefully as to whether commercial property funds are the best way to access it.
This article first appeared in the June edition of The Trade Press publication.