Brexit And Property Investors: A Reminder Of Why Open-Ended Funds Don't Really Work For Illiquid Assets

| About: Hansteen Holdings (HTHPF)
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Fallout from Brexit has hit several commercial property investment funds.

Many have now suspended trading after hefty jumps in investors selling out of them.

This has been a timely reminder of a fundamental flaw in open-ended property funds compared to closed-ended REITs and why I'd only ever invest in the latter.

Property investments do not really feature heavily in my investing universe. I don't own a house directly. Also, the only property-related investment vehicle I have my money in is Hansteen Holdings (OTC:HTHPF): a small, well-managed pan-European industrial property REIT (Real Estate Investment Trust).

I fully understand the appeal of direct or indirect property investment, however. That is why I did seek to make a (modest) move into the space a few years back. When I did I had to make a choice which, for me, was exceptionally easy: should I own an open- or closed-ended property investment? In other words, invest in property using funds or REITs.

For me, property funds were just never a viable investment. The continuing fallout from the Brexit decision in the UK is a fine reminder of why this was the case for me. There are many excellent, well-managed property funds out there. Yet their fundamental flaw is why I don't hold them. Here I will explain why in case it may be of use to anyone.

The Context

Brexit, of course, is hitting the headlines across the globe. Yet here in the UK (as you can imagine) it hits with a little more frequency. The most recent concern revolves around commercial property investment.

This week alone a number of large and small commercial property funds have suspended trading after there was a rush to get money out of them in the wake of the Brexit vote. In total, since the start of this week £18 billion in capital invested in these funds has been frozen. Quite striking.

This unfortunate series of events has been led by the simple disconnect inherent in property funds as opposed to REITs. Indeed, it was this disconnect which ensured that my property investment went to a REIT rather than a fund.

Funds: Illiquid Assets in Liquid Vehicles

Property funds naturally hold as their assets one of the most illiquid investment items: property. Property is not the easiest thing to sell at the best of times, yet when the property market is faced by genuine uncertainty and slowing sales it is even more so. Certainly sales can be made, but not necessarily at a good price.

The issue is that-being open-ended-these sales need to be made to cover any investors' capital leaving the funds.

Here is the thing. Investors can head to the exit from these funds easily. Their shares in the fund are highly liquid. Head over to your online broker, hit sell. Done.

In a healthy property market, usually there is a balance (of sorts) between sellers and buyers of property funds. An investor sells £1000 or so in shares, another investor picks up £1000 or so in shares. For the fund manager, little has really changed. They may have a little more or less capital. Fine.

However, if weaker market sentiment has left fewer investors willing to take up the shares being sold (that is, replace the outgoing capital) then naturally the fund managers have to find the cash to pay to outgoing investors. Usually they have enough spare capital to cover this. Yet, when they don't, they have to see down their assets (property) to pay the leaving investors instead. This is what is occurring right now.

Unfortunately, selling property is not a matter of just clicking a button and then heading off to make a cup of coffee. Property's inherent illiquidity (exaggerated in a slower property market) prevents this. Fund managers therefore have to find some way of reconnecting the disconnect between the liquid investment vehicle (ETFs, funds, etc) and the illiquid asset underlying them (property).

How to do this? Some have responded by cutting the sale value of the funds or hiking exit fees. By doing so, the hope is to make the wholesale exit from the funds less attractive. The liquidity of the investment fund is solidified a little by making it an unattractive point to exit.

Alternatively, you make the illiquidity of the fund line up with the illiquidity of the assets. In other words, you stop people being able to sell out of the fund. This has been, so far, the more common action by funds. Investors are then forced to sit holding their investment in the fund. This gives the fund time to:

  1. Sell the property to cover those investors who have left and plan to leave, and/or;
  2. Allow the market to settle a little to stop the unmanageable exodus from the fund.

Whichever they do, the effect is the same for the investor: they can do pretty much nothing with their capital tied up in the fund. Hardly an ideal state of affairs.

REITs: The Better Option?

For REITs this is less of an issue. Being closed ended means they are little affected by heavy selling. The capital in the business remains the same, as do the number of shares. When an investor sells out of the REIT, the REIT does not need to sell assets to cover them. In fact, the sale is only really directly relevant between the person selling the shares and the person buying them. The REIT manager can remain delightfully ignorant of the transaction if they so desire.

For investments in illiquid assets like property which can often see wild swings in investor sentiment this is highly attractive. The REIT managers can just carry on doing what they are doing. They can continue holding the properties until they find an attractive point to exit (if they wish) and continue picking up rent in the meantime. There is no need to sell property at a low point in the market because investors are rushing to the exit. This is a very attractive feature of REITs over property funds.

Share prices do affect the REIT, of course. Should they wish to raise further capital they can do so with a rights issue of new shares. A lower share price would, naturally, lead to less capital raised in that manner. Yet they can also head down the debt route which skirts around this issue.

For funds, however, this is not the case. Debt can't be taken on by the fund. Capital is raised (or lost) according to how much fresh investment joins or outstanding investment leaves. Hence why the above issue emerges.


For me, property funds always had a fundamental flaw in them: the illiquidity of their assets against the liquidity of their investment capital. The Brexit turmoil is a fine reminder of precisely what that flaw means in real terms. Investors are now sitting on shares in funds from which they cannot sell out.

REITs face their own issues in such an environment. Clearly if property prices decline on the back of a weaker economic backdrop, their property asset values also decline and along goes their share price (Hansteen is down 8.5% since the Brexit vote was announced). Yet any investor is familiar with those particular threats.

Funds really do have their places in an investment portfolio. I hold index funds as part of my portfolio and they work. An S&P 500 or FTSE 100 tracker is a liquid investment vehicle with liquid assets. You sell your shares in the tracker, the fund manager sells a little of each holding. Simple. For property funds you can't really sell a little bit of a property to do the same.

Property investment is a long game. For me, REITs and property companies generally are the most effective means of playing it. Property funds just strike me too flawed to be a viable investment. Even if you are an investor willing to hold on rather than sell out, would you be comfortable that the company is being forced to undertake a "fire sale" on potentially lucrative long-term assets to cover those who are leaving? I am not.

The events surrounding Brexit are perhaps a timely reminder for people currently invested in such funds to consider whether they are comfortable with this themselves. Brexit may well throw up some property investment bargains. I for one, however, will not be tempted by the property funds.


Creative Commons image reproduced from Flickr user herry.

Disclosure: I am/we are long HTHPF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.