With a heavy heart – and a heavier bill – Aviva told investors this week that after a tumultuous year for the fund, the firm will shut its main UK Property Fund as well as its two feeder funds on 19 July and return cash to investors “in a fair and orderly manner”. The current liquidity of about 40% of the fund will be returned (equivalent to about 40% of current value) but the rest will dribble back as asset sales are completed, which may take up to two years.
Like many other investment firms, Aviva suspended trading in its open ended property fund last March – just as the pandemic began and capital markets were in nosedive. Equity markets have long since recovered, generating impressive returns over the rest of 2020, but the gates never opened on Aviva’s property investments. Now they never will, with the group concerned that maintaining value – while keeping enough liquidity to fulfil redemptions – would be impossible.
As reasons for the closure, Aviva effectively cited the continued “material uncertainty” around its assets that had caused the initial suspension. An internal review found that generating positive returns while maintaining a suitable cash level for investors was not viable amid the fallout of the pandemic.
After a year of the deepest global recession on record, this might sound reasonable. But it sounds much less reasonable when you consider that now, and for some time, the global real estate market has been doing quite well. Like everything in the early pandemic, both commercial and residential property prices looked in trouble last March. But more recently, prices, trading volumes and interest have fared fairly well in almost all areas.
We have noted before how this has played out for residential markets across the world. For current and prospective homeowners, lockdown has bolstered current savings, employment is reasonably assured (with interest rates rises not expected to exceed pay growth), making houses just about affordable.
In the UK, an extended Stamp Duty holiday has pushed buyers into the market, initially in those previously underbought areas outside of the main cities. Office for National Statistics (ONS) data published on Tuesday showed house prices rose in March by more than 10% in annual terms – the biggest monthly increase since August 2007. Prices of detached houses rose 11.7% in the year to March. This week, with the delights of socialising returning, Tim Bannister, Rightmove’s director of property data, told us there is ” good news for city centres across Great Britain, with a number of agents now telling me they’ve seen a marked uptick in demand from first-time buyers.” Rightmove said buyer demand for flats in April stood 51% above pre-pandemic levels in February 2020, while ONS March year-on-year data showed an increase of 5.0% for flats and maisonettes.
Similar situations hold in the US, Australia and other developed nations, where consumers are putting stimulus cheques to work, and housebuilders are seeing strong demand. One exception is China, where property prices are faring relatively worse. This is almost certainly due to the relative tightness of China’s monetary policy – something we have pointed out several times. This suggests that the extremely accommodative monetary policy we are seeing around the world is driving activity, as expected.
In the UK commercial property market, Stamp Duty holidays do not apply. But, according to last month’s survey from the Royal Institute of Chartered Surveyors (RICS), commercial property in Britain is nevertheless undergoing a decent revival. There are longstanding issues in the commercial property market which have been compounded by the pandemic, from the ‘death of the high street’ phenomenon to an increase in working from home – lowering demand for office space. And yet, the RICS survey for the first quarter of the year shows respondents are confident of a recovery.
That returning confidence may be reflected in the relative performance of the FTSE350 REITs sector (REITs are publicly listed, close ended real estate investment trusts). The graph below shows the beginnings of outperformance relative to the FTSE350 index since the start of the year. Revaluations of net asset values happened through last year, and REITs are mostly trading at discounts which suggest those are generally not likely to start being pushed up. However, REITs are outperforming the recent rise in the overall FTSE350, which may tell us that investor perceptions of commercial property market values are improving in line with the survey.
Our point is not to be a cheerleader for the property market, rather to highlight that Aviva’s property fund troubles cannot be put down to economic or market factors alone.
There are certainly questions around how different parts of the market will respond as the recovery continues. Industrial and distribution space is doing well. We are not back to normal as far as retail and offices are concerned, but as people flock back into cities, some property developers are confident of what is ahead. For example, despite the empty offices, there is currently a building and refurbishment boom going on in the capital, as well as other major cities around the developed world. New construction starts have jumped by 20% between September 2020 and March 2021 to 3.1 million square feet, Deloitte’s London Office Crane Survey showed. Of this work, 56% involves upgrades of existing office stock.
“Occupiers’ needs are shifting and buildings that meet their ESG principles while taking into account the welfare of their people are top of mind. Grade A, well-connected and eco-friendly office spaces, designed to maximise the benefits of new ways of working, will be the most desirable,” said Mike Cracknell, director in real estate at Deloitte.
So, although overall property prices may have bottomed, changing demands from tenants means the most important factor in real estate asset performance is having the right space.
The problem – as with all open-ended property funds – is the way these funds are structured. Open-ended property funds promise investors the best of both worlds: exposure to the returns of the highly illiquid property market, but with the benefit of daily-traded liquidity. Investments that sound too good to be true usually are, and these funds are no different (which is incidentally also why we do not consider holding such property funds in our investment portfolios).
As investors in these funds have found out over the last year, liquidity turns out into a mirage as soon as the going gets tough. Most open-ended property funds are only just re-opening, more than a year after shutting their gates, and several that have opened have had to sacrifice huge chunks of their property portfolios – the bit that actually generates return – to do so. Aegon’s property fund is still struggling to sell its stock to reach adequate cash levels for redemptions. In April 2020, just after most funds had shuttered, reports came out that in aggregate, retail investors were paying nearly £10 million in monthly fees despite not being able to sell their investments.
Illiquidity bites open-ended funds especially hard at the bottom of cycles such as this one. End- investors may be trying to withdraw capital, but difficult properties find no buyers, while good ones are snapped up at what looks like almost ridiculous valuations. A fund, even a generally well- managed one, can find itself in the wrong place with no chance of rotating the portfolio. The graph below shows how Aviva found itself in the wrong space, while Janus Henderson seems to have played its hand better.
In truth, the stability offered by open-ended property funds is really just an inadequate form of risk- pricing. We can see this when comparing their performance against REITs (like the Great Portland REIT in the chart above), the structure of which we would consider much more suitable for portfolio inclusion. Unlike open-ended funds, REITs are companies whose value is based on their property portfolios, but can fluctuate day-to-day as the market moves. Investors may be put off by the volatility REITs go through – especially as property is often perceived to be a non-volatile asset. But again, this volatility is actually just an accurate pricing of the underlying risk, which can move around even when underlying property valuations might not.
As the recovery gathers momentum, property prices should benefit. That gives it a reasonable investment perspective, but investors should as always be aware of the risks they are taking. If that means the investment is clearly labelled as volatile, we would argue this is still better than papering over those risks with false promises.