Long-term savers around the globe have enjoyed the positive contribution to diversification that income-producing property can bring to multi-asset portfolios. The fact that direct property is relatively illiquid is not a problem for long-term investors and this risk is usually controlled by maintaining a modest 5-10% long-term weighting.
In the past 10-15 years, one trend has been for institutions to buy units in large, open-ended unit trusts (PUTs), which can provide better diversification and quality of income than direct property. PUTs’ liquidity reflects that of the underlying property; typically redemptions are paid after three months’ notice. Statistics from the Association of Real Estate Funds show that many investors prefer to trade units on the secondary market, which has had annual turnover of nearly £1bn in recent years.
Investors empower managers of these funds to defer redemptions for up to two years in exceptional conditions, such as the post-Lehmans crash, when liquidity and valuations can be severely compromised. This is not illogical. In looking to enjoy property’s long-term benefits, investors free managers to build portfolios of all property types to best replicate direct property performance. Some funds have delivered investors’ objectives for over 40 years, without any artificial liquidity mechanisms that create volatility and dilute performance.
One might assume that regulators would allow like-minded retail investors to co-invest in such prudent strategies alongside the professionals, but this is not the case. A series of anomalies ‘protect’ the man in the street from rational, long- term property investing. The FSA defines investors as professional or retail; ie as defined benefit (DB) pension schemes or ‘other’. This might not matter if DB schemes were not being gradually replaced by defined contribution (DC) schemes, which tend to allow participants to select their investments, so are classified as for ‘retail’ investors.
To protect consumers from risk, the regulator imposes minimum liquidity requirements on authorised vehicles. But such rules were written for more liquid securities markets and have only recently been crudely adapted to authorised property funds. There is something inherently risky about regulations that force liquidity on to a fund that invests in an underlying asset that may take three months to sell. But it is unfair to blame it all on regulations. Sales-driven providers have bolted property onto inflexible multi-asset platforms under the pretext that all retail investors need daily liquidity, with little regard to the impact on volatility or performance.
Little thought has been given to what retail investors want. They have no choice but to invest in strategies that construct artificial liquidity by using cash, bonds and equities as a realisable buffer, diluting the performance of the underlying property. The assets themselves tend to be the most liquid, and so the most expensive, typically sold at the bottom of the market and bought at the top, to satisfy the whims of short-term cash flow, rather than the needs of investors seeking longer- term performance from a stable property portfolio.
The introduction of Property Authorised Invest-ment Funds (PAIFs) provides a welcome, tax- efficient structure similar to unlisted REITs. But managers’ plans to launch such funds in the FSA regulated space have highlighted the existing anomalies, which are further emphasised as the UK adapts to EU laws such as the Alternative Invest-ment Fund Managers Directive and Solvency II.
While protecting consumers is of paramount importance, appropriate risk warnings can be reinforced to give retail investors the power to challenge the platforms and demand direct access to a greater choice of funds offering a range of styles to meet their needs. With an increasing number of ‘other’ investors being disenfranchised from their right to access the benefits of long-term property returns, it is time for a root and branch review of the rules governing property funds, as a catalyst to the creation of new funds meeting all investors’ needs.