“History does not crawl, it jumps,” writes Nassim Taleb in The Black Swan, his book about the impact of highly improbable events. The performance history of UK commercial property funds often show a crawl – although headlines in the personal finance and industry press over the last six months have certainly jumped when it has come to their suspension.
This particular ‘jump’ for property has of course been going on for more than four years, following the mass redemptions and temporary gating of the UK’s largest open-ended commercial property funds in the wake of the Brexit referendum.
The FCA is now consulting on how to address the potential harm arising to investors from open-ended daily redemption funds, which invest directly in property assets such as offices, shops, restaurants and warehouses that lack liquidity. There is the potential for a liquidity mismatch between the investor and investment where the fund is unable to meet redemption requests.
The Financial Ombudsman Service (FOS) has also had an increasing focus on property, dealing with complaints such as funds being unsuitable for the customer, delays in withdrawing money and customers not being told about potential deferral periods from the outset.
Averages are deceptive
Taleb’s book is all about the relative frequency of improbable events and preparation for their potential magnitude. He talks about not seeing the ‘huge trees’ because of too much ‘focus on the grass’.
In portfolio terms, that would be the focus on average performance and average volatility – which, while helpful for more liquid asset classes, can look quite benign for property funds – versus value at risk and the potential for extreme losses at the tail end of a distribution. In an earlier column, Look beyond averages, I talked about the risk of wading through a river that on average is three feet deep but has a seven-foot-deep pothole. Averages can be deceptive.
The particular impact of the pandemic as social distancing stopped people from going into offices and, for a long period, stopped all but essential shopping and eating out was so rare and so extreme that few people thought it possible and even fewer built resilience into their planning to manage for it.
Yet here we are. At the time of writing according to the latest RICS Survey, capital value expectations for the coming three months are down 32% for offices and 71% for retail as a result of social distancing measures and forced business closures. Independent valuers are unable to value property portfolios with sufficient certainty –hence the open-ended funds need to suspend.
Given the risks, then, what role is there for commercial property or infrastructure in a long-term portfolio? As an asset class, commercial property has three important characteristics;
* Cash flow: Property can provide investors with a relatively stable source of income in a low interest rate environment, via regular distributions or rents after expenses, which should keep pace with inflation and help maintain real returns.
In the short term, portfolio rents are under stress – however, longer term, we have to assume sustainable tenancies will again be in place and the market will benefit from growing areas of the economy, such as pharmaceuticals, life sciences and technology, and ultimately in server farms, distribution centres and pipelines.
* Capital growth and appreciation: This is on the basis that, in a growing economy, the demand for commercial property will drive prices higher over time. Clearly, in the short to medium term, this may not be true for offices and retail but the picture is complex and dependent on country or region, location and use. In the UK the government’s new town planning laws, for example, hope to revitalise town centres by making change of use far easier.
* Diversification benefits: Property as an asset class is less correlated to equities and bonds overall and so can provide something meaningful in terms of risk-adjusted returns.
Liquidity profile
Commercial property can make sense as a component in a diversified portfolio – the question is how to access it in a way that is suitable and manages or mitigates the risks associated with its liquidity profile. There are four main considerations based around the client’s risk profile and financial plan:
* Overall exposure: When viewed through the lens of historical performance, OIECs can look deceptively attractive, missing out the liquidity risks and costs. Comparing the performance of a tradeable real estate investment trust (Reit), for example, with a direct property fund shows this clearly. Matching the client’s risk profile with a property component needs to reflect this risk. Over time, our approach to this is to have gradually reduced the Dynamic Planner benchmarks’ exposure in the property bucket to 5% across all risk profiles from 2 through to 8 out of 10.
* Liquidity: Providing access to the returns provided by property while reducing the potential negative impact of liquidity in solutions through a daily priced mechanism can help suitability in the long run. The use of Reits in multi-asset solutions allows access to the cashflows of illiquid assets without subjecting the portfolio to the liquidity risk of the underlying assets. Reits, however, introduce more equity-type risk and so overall exposure remains an important point. Our benchmarks use a mix of both direct exposure and exposure to investment trusts – however, the important point is to do what best meets the needs of the client.
* Country and region: Even though a target risk profile might be high, emerging market property, for example, introduces additional risk, such as currency risk. Again matching is important.
* Underlying holdings: Researching the individual securities held by a fund or trust and calibrating those to capital market assumptions, enables a more accurate assessment of the solution’s potential risk. Of the 1,261 funds and DFM model portfolios risk-profiled by Dynamic Planner, for example, 31 solutions use only physical properties, 569 solutions use only Reitss while 52 use a mix of physical property and Reits. Out of the 120 risk-targeted solutions, two use physical property and 65 use Reits. We map these to more than 25,000 individual securities.
Given its long-term investment benefits, property has a place in a multi-asset portfolio. Matching the portfolio to a target risk profile and liquidity characteristics, however, requires careful consideration on both how that exposure is gained and in what quantity so that, if and when ‘history jumps’, client portfolios remain suitable.
Ben Goss is CEO of Dynamic Planner
