Real Estate Fund Investors Pulling Out

I came across an interesting article recently on the Financial Times website. It is interesting for a a number of reasons which I will discuss. This is the article in question -

A comparison has been drawn between the recent halt to redemptions from open-ended property funds in Europe and the situation in Germany in late 2005/early 2006. At that time, temporary fund closures and subsequent restructuring were necessary due to portfolio valuation reviews and a general loss of investor confidence. Today, however, redemption restrictions do not stem from "self-made" issues within the commercial property industry but from the turmoil within the financial markets as a whole.

The current heightened redemption levels have not been caused by a mass withdrawal of cash by a large number of retail investors. Rather, the trouble has stemmed from a few large-scale institutional investors withdrawing big chunks of capital motivated by the liquidity problems they face internally. Their strategy of reducing exposure to commercial property is debatable since real estate investments have outperformed equity investments in most instances. With most of the affected funds frozen for periods of at least three months, it is important to consider how liquidity levels can be increased during this time. For those funds not supported by temporary liquidity injections from parent companies, there are typically three main approaches: continued retail and institutional investment, selling assets, and restructuring property finance to achieve higher leverage ratios. But how effective can these tools be during this precarious financial climate?

Funds that have been frozen may be able to generate liquidity naturally, whilst frozen, funds can still benefit from incoming cashflows generated by investors purchasing shares. Furthermore, liquidity will be secured via organic growth, generated by rental income surplus and interest earned on the remaining liquidity.

However, this is unlikely to raise a fund's liquidity ratio to a comfortable short-term operating level.

Fund managers also have a part to play in securing liquidity. When redemptions were halted by these property funds some selling orders had not yet been exercised. These will be executed once the fund reopens, so it is essential for the fund manager to convince potential sellers to reconsider.

While fund managers may be able to stave off some existing redemptions, raising fresh capital will be difficult. Retail investors are more likely to prefer the safe haven of state-backed securities or guaranteed saving deposits. As institutional investors continue to reconsolidate their portfolios, it is likely to be difficult to raise capital in the open financial markets upon reopening.

Given the problems associated with raising fresh equity from investors, funds can either attempt to sell properties, or can align with financially strong joint venture partners who take over minority shares on an individual special purpose vehicle or fund level. But with property yields increasing by 200 basis points and a lack of operative buyers due to tighter credit conditions, this may not be a viable option. Furthermore, actual property sales below book value would only crystalise real losses.

The third alternative is to refinance the portfolio, targeting a higher loan to value ratio and therefore releasing additional liquidity. However, this may not be a sustainable approach, as finance is only available at very high margins.

So what is the way forward for the funds upon reopening?

Ill-considered redemptions are not the answer: fundamentally these are well-performing long-term investments and should be treated as such.

Frozen funds must focus on adapting to the current financial circumstances and explore alternative options for raising capital. One solution may be to consider other potential sources of finance over traditional lenders; in the recent past, sovereign wealth funds and Canadian pension funds have been increasingly interested in European real estate investments.

Another option may be a change in management structure and fees to increase the dividends, motivating investors to maintain their shares within the fund.

Another possibility will be the adjustment of fund regulations. Recent proposals put forward to protect the funds from panic selling include a longer withdrawal notice period required for larger amounts of investment, and maximum payments to each investor in difficult periods.

So far, actions taken by fund managers have ensured that investors have realised minimal losses and dividends for the most part have been unaffected. When turning again to the 2005/2006 situation, frozen investors at that time still managed to achieve relatively high returns. This is a time for investors to hold tight. Source.

A fairly well written argument arguing for commercial property fund investors to hold tight because these funds are a fundamentally sound long term investment. But, and this is a rather large but - this article was not written by an impartial journalist, it was written by Timo Tschammler, managing director of international investment at DTZ, a "real estate advisor."

It is very much in DTZ's interest to persuade investors in commercial property funds to leave their investment in place, not because it is in the best interests of investors, but because any more withdrawal of funds will be a major issue for DTZ. their shares have fallen from a one year high of £279 and are currently trading at around £28. A drop of almost 90%. This down from a recent high of over £800 as recently as 2007.

Quite apart from that, the fact is that the commercial property sector in both the UK and the US faces some enormous challenges in 2009 from which I suspect they will not recover from in less than seven years. British commercial loans are set to default to the tune of £70 billion this year, with the Financial Times themselves reporting on the dire outlook, and the US commercial property sector is in even worse condition. I personally see many of these funds failing in 2009.

I am not entirely sure what the FT is doing by allowing this to pass as journalism, but I suspect it is one of the few times where the writer needed to pay to write.