The pros and cons of investing in property funds
Commercial property funds tend to be very popular with retail investors but the asset class comes with its fair share of risks. We look at some of the pros and cons.
What you’ll learn:Click to toggle accordion What you’ll learn:
The types of property funds available.
What the attractions of property funds are.
What are the main risks associated with the asset class.
There are two main types of commercial property fund. The first, and typically the most popular, is direct property funds, which buy commercial real estate such as industrial and retail parks as well as office blocks. The aim is that the rent from these properties should provide a steady income for investors, who can also potentially benefit from any capital appreciation.
Money invested in this type of fund is spread across a range of different properties, which helps with diversification and ensures that if one or more properties are unoccupied for a period of time, the others can still generate income.
The second style is indirect property funds, which invest in the shares of firms that operate in the property and property development sector and as a result, their performance tends to be much more linked to the wider equity market.
There are also funds that take a hybrid approach, investing both in direct property and in property-related securities.
The main attraction of property funds is not only that they can potentially provide a good source of income, but also that they can offer investors an extra layer of diversification. That’s because bricks and mortar typically has a low correlation to other asset classes, such as equities and bonds. Essentially this means that property tends to perform differently to other investments in response to different market conditions.
How property funds are structured
Property funds can either be open-ended, such as unit trusts or open-ended investment companies (OEICs), or they can be closed-ended, such as property trusts or real estate investment trusts (REITs).
Unit trusts are established as trusts and will issue units to investors, while OEICs are incorporated as a company and will issue shares. The fund manager buys back units or shares from investors wishing to leave the fund.
The value of the units or shares in a unit trust or OEIC rises or falls based on the value of the underlying assets the fund holds. Most funds are valued once per day, and each day this establishes the price at which investors may buy or sell units in the fund.
The other main type of property fund, closed-ended funds such as investment trusts, are stock market listed and traded like stocks. As these shares can be traded throughout the day, they don’t face the same type of liquidity issues that open-ended funds have to deal with. When an asset is considered to be ‘liquid’, it essentially means that it should be easy to sell at a reasonable price, but property is viewed as ‘illiquid’, because it’s usually difficult to sell quickly at the right price. When investors want to sell their holdings in open-ended property funds, the underlying buildings have to be sold, whereas if investors want to sell closed-ended funds, they simply sell their shares.
Closed-ended funds issue a set number of shares, so once these are all in circulation, investors must purchase them on the market, as they would with any other stock.
What are the risks?
There are two significant risks associated with property funds. As well as being a highly illiquid asset class, property values can be very volatile, which can make for a bumpy investment journey.
While most property funds will hold a proportion of the fund as cash to meet investor redemptions as and when they arise, when a very large number of investors decide they want to cash in, serious problems can arise. If the manager of an open-ended fund doesn’t have an adequate cash buffer in place, they’ll have to sell some properties so they can reimburse exiting investors and this can’t be done quickly.
For example, during the global financial crisis of 2008, UK commercial property values plummeted and investors en masse attempted to withdraw their capital. More recently following the referendum on Britain’s membership of the European Union, many investors once again got spooked and started to withdraw their money on the back of concerns that a departure from the EU could have a negative impact on commercial property prices.
On both occasions, a number of open-ended funds had to be suspended because too many investors moved to cash in their holdings at the same time. Fund managers stopped repurchasing units and shares and investors were unable to sell their holdings. Under such circumstances, investors can’t do anything and need to stay put until the suspension is lifted. Investors in suspended funds do however, continue to receive income from the portfolio.
What about ‘fair value pricing’?
Property funds can also introduce what’s referred to as ‘fair value pricing’ which can deter redeeming investors. This means a fund manager makes adjustments to the value of their assets based on their estimates of the current likely values of the fund’s property holdings, if it had to be sold at short notice. The ‘fairer’ dealing price takes account of the fact that properties coming to market now may not achieve recent valuations. The primary aim of this is to prevent sellers from receiving too high a value for their shares, which would impact long-term investors in the fund. It also means that when investors want to cash in their investments, fund managers aren’t forced to sell the buildings they invest in at short notice, which could mean they’re unable to get as high a price as they would if they were able to wait.
For investors stuck in suspended funds, even when the restriction is lifted they could find that fair value pricing has been applied and they’ll need to decide whether or not they want to sell their holdings at a discount.
As the shares in closed-ended funds, such as property trusts and real estate investment trusts (REITs) are listed and traded like stocks, they don’t face the same liquidity issues that open-ended funds have to deal with. Investors can sell their holdings more easily if they want out – they simply sell their shares. However, listed property funds can see their values fall very sharply if the sector takes a turn for the worse, as can open-ended funds that invest in property company shares.
Despite the risks involved, commercial property is still generally viewed as a good diversifier, but investors need to be comfortable taking on the risks involved, namely price volatility – the potential for big falls in value – the asset class’s illiquid nature and open-ended fund managers’ powers to suspend repurchases and revalue assets.