PD/IPF conference: Downturn is a tough teacher for property fund managers

Adapting to survive in a post-recession era was main theme of IPF/IPD event, writes Jane Roberts

At last year’s IPD/IPF Property Investment Conference in Brighton, property fund managers admitted they were taking as big a battering at work as they were from the rain on the seafront. Terrible performance, run-away gearing and liquidity problems were the topics at the bar and in sessions.

The mood at this year’s conference was still sober, but the emphasis was on learning and applying hard lessons, and exploring the UK market’s prospects, particularly in light of the past few months’ sharp rise in values.

Speakers agreed that as well as forecasting the market, investment managers must adapt to many changes. These include: meeting the demands of activist investors; ending fees based on debt-inflated gross asset values; structuring and valuing funds and portfolios to improve liquidity; and dealing with greater regulation and less new business.

In the ‘New models for property investment’ session, Guy Morrell, head of HSBC’s property multi-manager business, argued that fund-managers should have seen the crash coming: “A lot were ill-prepared and should have served their investors better,” he said. He added that they hadn’t kept a close enough eye on liquidity or gearing risks, eroding returns and leading to fire sales.

One lesson was to pay more attention to market pricing (see fig 1). Everyone tracks the relationship between property initial yields and five-year gilts and knew that gap turned negative in 2006. “They should have known how expensive property was becoming; yield changes imply either rental growth expectations or additional risk, or both,” Morrell said. “The market was massively over-priced.”

A related lesson was that managers should sell early in the cycle to meet potential redemptions and stop promoting funds. Morrell was even less impressed with closed-ended than open-ended funds; he said his team has carried out due diligence for investors on 120 funds, about half covering the UK, but only considered open-ended funds, due to a lack of liquidity in closed-ended vehicles.

The lack of an independent platform to trade secondary fund units and improve liquidity – a point raised by Nabarro’s Deborah Lloyd – was one reason why he avoided closed-ended funds. “I just don’t like them; there isn’t any liquidity, and the pooling argument is partly negated because you get lumpy lot sizes. This is risky, then gearing makes it even riskier.”

Co-speaker Bill Hughes, chairman of the Association of Real Estate Funds (AREF) and head of Legal & General Property, agreed that secondary liquidity may be desirable and was more likely in vehicles with more investors, but he didn’t “think investors in closed-ended funds should expect it”.

Other co-speaker Simon Redman, Invesco’s head of product management, said many investors in small funds didn’t want secondary trading: “A lot of our investors are dead against it; they don’t want an investor they don’t know coming in.”


Hughes’ reply seemed to imply that an independent trading platform was not an AREF priority. Morrell countered: “We would like to see an arrangement like that, then we might look again [at closed-ended funds].” This suggests more investors would invest indirectly if there was more liquidity.

Hughes agreed that managing liquidity had been open-ended funds’ biggest issue, but that the big deficiency in closed-ended funds was poor management of gearing.

He criticised inappropriate use of debt  and “gearing by stealth”, but said balanced funds had managed debt better and been lower geared than most specialist funds. “Don’t compensate managers by gross asset value; ensure fee structures promote the right management behaviour,” he said.

Hughes also argued that open-ended fund managers had given “poor explanations of liquidity mechanisms”, and that in future, they should “focus on holding assets with high liquidity and provide clear strategies for selling assets ahead of market deterioration”.


They should also hold sufficient proxy for property with guaranteed liquidity and only use debt exceptionally, to manage liquidity. A presentation by Redman underlined the reality of less new business and focused on what he thought investors wanted now.

Redman said a five-fold rise in property funds launches (see fig 2) was a growth rate “turbo-charged by debt” that would have been unsustainable even if the downturn hadn’t halted expansion last year.

“I don’t believe we will see anything like as many launches as before, but there will be more than in 2009,” he added. Of the up to 80 new launches being talked about, “only a handful will succeed”, he predicted. While real estate investment may rise in 2010, “this (equity) will be balanced by a reduction in debt”.

Redman said investors will want greater clarity following exposure to over-leveraged funds, which has been “like putting money into a black box”. He understood why Peter Pereira Gray of Wellcome Trust said he would only invest via boutique investor club deals that would give him greater influence.

Redman was against reducing manager discretion, however, saying: “Managers are appointed to make fiduciary decisions and reducing their discretion can be a bad thing; it takes away their management account-ability.” But he said “discretion in a box”, where a manager can only invest within certain parameters without investors’ consent, “will become a lot more common”.


Reporting, debt strategies and decision-making should be clear, Redman said. “Investors will tighten up on strategy drift, where people set up a fund, find it isn’t working and change the strategy”. He also warned that “regulatory creep…will have an impact and we don’t know where it will end”.

The chairman of the conference’s first day, PRUPIM managing director Martin Moore, agreed that property investment management was sure to be more regulated. Asked how the industry could avoid a repeat of the collapse of New Star Asset Management, he replied: “In future there will be a regulatory overlay… There are product features and issues we can improve; we can do a lot about the way we structure portfolios for liquidity; and marketing should never be investor-led”. AREF’s Hughes went further, saying: “I think [New Star’s] sales team were determining the direction of the funds.”

Moore said that in 2006 and early 2007, PRUPIM “made it clear internally” to their Prudential and M&G sales colleagues, “that we thought the market was unattractive. The retail bank then put a limit on how much customers could invest in property”.

The controversial issue of pricing open- ended funds in a falling market where managers have some latitude about setting redemption procedures was aired on the second day in a session chaired by John Gellatly about IPF papers published this year.

Neil Crosby and colleagues at Reading University suggested that valuing units was one area where valuation had failed in the downturn, another being banks’ valuation methods in continuing to lend at 80% loan to values when market values rose 30%-40% above investment value.

Crosby said the UK had “the best valuers in the world”, who had sliced away at values by an average 2.5% per month between June 2007 and March 2009, “but that still wasn’t enough for property unit trusts, who suggested (in Brighton last year) that all of that fall had taken place by September 2008. It led to some managers closing funds to redemptions rather than allowing redemptions at current valuations.

“Valuers look at the direct market only; could they take softer signals into account to inform price changes?” Crosby asked. Ways of operating get challenged in adverse times, Moore said, and “some things need challenging”. But he warned: “The speed of the correction could lull us into a false sense of security or complacency, before the lessons have been learned.”


Golden years or double dip: a look to real estate’s future

Forecasters are split about the prospects for UK GDP growth and inflation, as Peter Hobbs, RREEF’s head of research, illustrated in a presentation on property investment in a post-recessionary environment (see fig 5).

In light of “huge uncertainty” RREEF has devised four scenarios for the next four years, based on whether the UK economic recovery is strong or weak, overlaid with two other factors that drive property performance: property fundamentals (supply, demand, and vacancy) and capital markets.

At one end of the scale is the possibility  of four ‘golden years’, with the economy picking up strongly, rents still falling, then recovering, and capital surging back into property, driving yields down (see fig 3). “But more probable is a double dip like the mid 1990s, where yields stall,” he suggested.

Presenting an IPF paper called ‘Repricing property risk’, Legal & General Property strategy adviser Gerry Blundell said property’s risk premium will be higher in future. Factors such as the indirect effect of gearing, shortening leases and the impact of climate change and regulation combined “to suggest that 4% is the risk premium”. He added:  “Several times at this conference people  have talked of a spike in bond yields soon,” implying that yield compression is unlikely to be sustained without improved rental expectations. “This is a bi-polar industry that has flipped from pessimism to optimism and may flip back again next year,” Blundell said.

Speaking in the same session, Malcolm Frodsham of IPD said property income is much less robust than in the previous cycle. He reminded the audience that almost two thirds (62.5%) of leases had less than five years to run at the end of 2008, compared with a third (32.6%) in the 1992 downturn.

UBS asset allocator David Buckle said property looked attractively priced now – but wasn’t necessarily a buy when equities were at least as attractively priced, but without the liquidity problems property is still perceived to have, despite the advent of derivatives.

Richard Barras of Property Market Analysis saw the “bubble in asset prices as an after- shock of the main shock”. He predicted a decade of deleveraging and accelerating depreciation of office and retail space, as an IT and low carbon-economy implied a shift away from commercial to housing and a continuing rise in internet sales. “The residential market is seriously undercapitalised and undersupplied. Capital from the oversupplied commercial market needs to switch over”. He concluded that investors should confront the possibility of declining growth and increased instability in coming years.