The problem with open-ended property funds is that the liquidity required by regulators is incompatible with investing in real assets – how can we resolve this?

When it comes to investing, the illiquid nature of real estate is its defining characteristic relative to investing in equities or bonds. This illiquidity is the prime explanatory factor for the risk premium over the risk-free rate of investment and gives property investors the returns profile and diversification benefits they seek, assuming they are investing for the long term. An asset class with round-trip costs (to buy and sell) of 8.5% and an average hold period (for institutional grade assets) of 5.5 years is not a natural fit for a fund structure that is required, by Financial Conduct Authority prescription, to provide daily pricing and be daily tradable. Open-ended property fund structures that deal in inherently illiquid assets should be seen for what they are – or rather what they are not, which is fit for purpose.

The recent consultation announced by the FCA on proposals to introduce redemption notice periods of at least 90 days and potentially up to 180 days is another half-baked measure in an attempt to resolve the long-recognised failing of open-ended funds investing in inherently illiquid assets, that of the liquidity mismatch. The Woodford Investment Management fiasco last year and the closing to redemptions of the open-ended property funds again this year (this time due to ‘material value uncertainty’) have brought this issue back onto the regulator’s radar.

Property fund managers trying to pool long-term institutional capital with short-term retail capital (and its contingent regulatory constraints) through the accumulation of real estate has become a modern-day Gordian knot, impossible to resolve. The increasing popularity of the platform investors that pool retail investor capital into ever larger flows into and out of asset classes on a whim, according to their models, has exacerbated this problem.

Tugging on one side of the knot is the FCA, trying to uphold the protections provided to retail investors. On the other side are fund managers, going about their daily job of finding, buying and managing properties to realise value for the long term. As attractive and altruistic as it sounds, such an investment proposition allows little regard for the hedging of market risk and liquidity planning in the event of a market shock or downturn.

Sitting on the fence but leaning towards the investor groups they represent are: the Investment Association (which on the one hand asked the Bank of England and the FCA, in an open letter, to keep markets open regardless of how bad market conditions become but on the other hand argues that it is acceptable for property funds to close “in certain situations”) and the other industry bodies and consultants. The stasis of the various stakeholders in trying to resolve this liquidity mismatch is a moot point, given that, like the Gordian knot, it cannot be resolved.

The only way to be rid of this impasse is through the open acknowledgement that the illiquid nature of real assets does not, and never will, satisfy the regulatory requirement of daily pricing and daily trading. The liquidity that is required by regulation for retail investors is diametrically opposed to the illiquidity rendered by investing in real assets. A consensual realisation by all stakeholders of this fact is needed to resolve this problem once and for all and would be akin to Alexander the Great cutting through the original knot of Phrygian Gordium with his sword.

Liquidity in these fund structures, according to former Bank of England governor Mark Carney, is “at best a lie” and at worst a fudge, with the small print in the prospectus allowing for ‘gating’ or ‘closing’ to redemptions when the fund’s ability to manage liquidity comes unstuck in extremis. For some funds this has occurred three times in the last decade and even twice in the last four years. While portrayed as being exceptional, a tail risk, and in the case of the pandemic due to ‘material value uncertainty’ (and according to some commentators therefore not having anything to do with liquidity – which is not entirely true), such occurrences are actually relatively frequent and will continue to be so for as long as these structures remain in situ. The most effective liquidity tool employed by fund managers to manage redemptions in property funds to date has been the holding of cash, but this is counterproductive to investor returns and defeats the purpose of investing into these structures in the first place.

To its credit, the Association of Real Estate Funds, supported by the Investment Association, is keen to push for change. It has identified and articulated a new structure that awaits regulatory approval: the professional investor fund or PIF. This is a direct response to the liquidity mismatch issue. Its solution is to ban retail investors from participating altogether. These funds will only be available to accredited investors with £1m or more to invest. While doing nothing for retail investor demand, at least this solution acknowledges that commercial real estate investment is a natural match for, and attracts, long-term investors seeking long-term income.

So, what will happen to retail investors looking for a liquid property fund solution? Such a solution will require a fund with the complexity and sophistication to manage various layers of liquidity accessed through different types of real estate investment product with modern liquidity management tools and expertise. Such a fund would probably invest in listed REITs, listed property assets on the IPSX exchange, unlisted property funds and debt-related products, and would be likely to use derivatives to assist with market risk and portfolio risk management.

Innovation is not in the property fund manager’s DNA and the property industry is generally laissez-faire, preferring to react to regulatory changes and demands as and when they arise, but in this fast-changing, digital and increasingly risky investment environment the property industry needs to take the initiative and innovate to provide a suitable fund structure for retail investors – before Google and Amazon do it for us, hoovering up the pools of retail money in the process.