Open-ended property distress and the rise of REITs
Marc Haynes (pictured) is senior vice president EMEA at Cohen & Steers.
Commercial property funds have proved enormously popular, with investors drawn to their strong returns, high income and portfolio diversification benefits. But in July, many popular ‘open-ended’ direct property funds were forced to suspend trading following a wave of redemptions unleashed by the Brexit turmoil. Others imposed ‘valuation adjustments’, penalising investors looking to sell.
As market conditions stabilise, investors caught-up in these funds are celebrating the gradual removal of these restrictions. But as a state of normality returns over the coming weeks and months, we call on the industry to once and for all address the structural flaws of open-ended direct property funds: namely they invest in something inherently illiquid – physical bricks and mortar – and thereby any liquidity offered can be illusory and unreliable.
After the collapse of the open-ended direct property fund sector in 2008, it seemed inconceivable these funds would return to popularity – but they did. In stressed conditions, liquidity can dry up, but when times are good and the supply of capital is strong, liquidity is typically never a big issue. Add to that, the tendency of investor forgetfulness, or perhaps a conviction ‘things will be different next time’.
But after two crises in relatively short succession, perhaps lessons will now be learnt and we will ultimately follow the path of Australia, which experienced its own issues with unlisted property trusts (UPTs, Australia’s once popular open-ended direct property funds) not once, but twice – first in the early 1990s and more recently during the financial crisis in 2008.
Faced with accelerating withdrawals in both instances, UPTs suspended redemptions, with estimates of up to £11bn being affected by freezes in 2008. Investors then voted with their feet – or wallets – and generally turned their backs on the UPT market, embracing instead the listed real estate market, which has developed dramatically over the last decade.
An outperforming alternative – REITs
REITs and other real estate securities are a typically natural fit for open-ended vehicles given they provide underlying liquidity, while the funds investing in listed securities have in large been successfully tested through both the financial crisis and again through the recent Brexit volatility.
The high level of liquidity typically afforded by public equity markets provides efficient access to and management of capital and daily market-cleared prices. REITs fund managers have the ability to manage through cycles by making tactical calls on geographies and property sectors that would be impossible to make in the private sector.
REITs also offer compelling performance, with real estate securities historically offering strong returns relative to direct real estate. The performance comparison is clear when looking at the highly developed US REIT market against open-ended physical property funds.
Annualised performance of listed REITs, as measured by the FTSE NAREIT Equity REIT Index, was 11.3% over 15 years to 30 June 2016, in dollar terms.
As for core private real estate funds, as represented by the NFI-ODCE Index, the performance was just 7.9% annualised over the same period. Performance over a shorter term time horizon also favours listed REITs, with 13.6% to 13% annualised over three years to 30 June 2016.
REITs also have above-average dividend yields, due in large part to the minimum distribution requirement for companies structured as REITs. Global REITs were yielding 3.55% at 30 June 2016, well ahead of many equity and fixed income assets. REIT vehicles also have a history of consistently raising dividends.
REIT valuations remain attractive
While REITs have witnessed a seven-year period of strong absolute and relative performance, we believe global real estate securities continue to offer attractive return potential. This is based on our favourable supply-demand outlook, continued access to capital and reasonable valuations. However, in a maturing cycle, we believe active stock selection and geographic allocation is critical.
While we are underweight the US after witnessing strong performance from February’s lows, we maintain a generally constructive view of Europe’s property markets, particularly in dominant shopping centres in major city centres.
We are also very constructive on the medium term growth potential for German residential properties, particularly in major cities such as Berlin, where demand far exceeds supply.
As for the UK, we were very cautious toward London office and residential companies in the months ahead of the Brexit vote, based on our concerns about slowing rental growth and peak valuations in these markets.
We continue to have minimal exposure. We have increasingly favoured UK companies we believe exhibit more defensive or structural growth characteristics. These include landlords in sectors such as self-storage, logistics, student housing and healthcare.