The financial world coped with the shock of the Brexit vote surprisingly well. The value of the pound dropped sharply, of course, and there was turbulence on stock and bond markets.
But there was no market freeze like that after the fall of Lehman Brothers in 2008, and no bank run like that on Northern Rock in 2007. In fact, banks held up rather well, despite their share prices taking a beating.
But in the mutual fund world, it was a different story. Runs on open-ended real estate mutual funds were so bad, some of them were forced to stop people taking their money out. Other funds have been forced to slash asset valuations, resulting in losses for their investors.
Mutual funds are companies formed of groups of investors – often, people saving for their retirements. These investors pool their funds and employ professional fund managers to manage their investments. Their investment in the fund is their “shareholding”, and its value depends on the valuation of the fund’s investment portfolio, which varies with the market prices of the assets within it. This is known as the Net Asset Value, and it is calculated daily (“marked to market”).
Investment trusts, unit trusts and real estate investment trusts (REITs) are all types of mutual fund. And mutual funds invest in many types of asset. Some – money market mutual funds (MMMFs) – lend cash to other financial institutions. Others invest in stocks and bonds. And some buy illiquid assets such as commercial property.
A property investment fund uses investors’ money to purchase large commercial properties such as shopping centres, office blocks and warehouses. As anyone who has sold a house knows, selling property is not something that can be done in a hurry: property sales and purchases typically take months to complete. So the assets in these funds are “illiquid”, meaning they cannot be quickly sold for cash. Money tied up in such investments cannot easily be withdrawn.
Closed-end property funds do not allow investors to withdraw their money, though their shares may be traded on a secondary market. But open-ended ones do. This creates the sort of mismatch that we see on bank and building society balance sheets.
Banks and building societies typically have long-term loans on one side of their balance sheet, mostly secured against property, while on the other side, they have deposits which can be withdrawn on demand – current accounts, no-notice savings accounts and short-term commercial deposits. Similarly, these property funds have property assets on one side of their balance sheet and the equivalent of demand deposits on the other side – shares in the company which can be sold back to the company at any time.
When there is a bank run, lots of depositors withdraw their money at the same time – but a bank which has invested the money in illiquid mortgage loans can’t easily obtain the money to pay depositors. A bank run forces banks to sell assets quickly at knock-down prices.
This can be highly destructive, as those who lived through the Northern Rock bank run will know. So we have deposit insurance to discourage depositors from demanding their money back, and the Bank of England lends money to banks to enable them to meet deposit withdrawal demands.
Open-ended property funds have a similar problem to banks. Investors can exercise their right to sell their shares back to the company at any time. But the funds don’t have insurance against the possibility of shares being dumped by investors, and they don’t have a central bank backing them up.
And because these funds can have problems finding immediate cash to pay investors who wish to sell their shares, they tend to keep a significant proportion of their investments in the form of cash, so that they can meet demands for withdrawals.
Some funds keep as much as 20% of their investments in cash. These cash reserves are similar to cash reserves in banks. They are there to enable people to withdraw their money.
But just as in a bank run, depositors’ demand for money can exceed a bank’s available cash reserves, so investors’ share sales after the Brexit shock threatened to overwhelm the cash reserves of several funds. Fortunately, the terms and conditions of these funds include a clause allowing them temporarily to stop people selling their shares, just as banks can close their doors to stop a bank run. So they did.
The clause allowing the funds to stop people selling their shares acts as a safety valve. Standard Life, which suspended redemptions for 28 days, said it gave them time to obtain fair prices for the properties they would have to sell to meet investor demands for cash.
Had the funds not suspended redemptions, we would have seen fire sales of shopping centres and office blocks. We would also have seen enforced fund closures, since selling commercial property even at a hefty discount can’t always be done quickly, and heavy losses for those investors who did not remove their funds in time.
Closing the doors preserved an important principle: mutual funds are supposed to treat all their investors equally, and closing the doors denied worried investors their right to redeem their investment, but it ensured that any losses fell equally on all investors.
And despite some funds suspending redemptions, losses there are. Commercial property, especially in London, has become a magnet for investors, particularly from overseas. Prices have been rising rapidly, and there has been some market concentration (fund managers investing in each other’s funds), which can create a dangerously leveraging spiral. So in a way, the Brexit vote shock has been a good thing. It has pricked a developing bubble in commercial property.
Commercial property is not just an investment: it has a real social purpose. Losses for investors may be gains for society as a whole
But for investors denied the opportunity to withdraw their money, the unpleasant reality is that their funds are no longer worth what they were. Investment manager Hargreaves Lansdowne reports that property fund managers are slashing commercial property valuations by up to 15% in anticipation of falling prices.
Their rationale is that the UK faces a period of uncertainty and slower growth: people will shop less (so less need for shopping centres and superstores), businesses will shrink or move overseas (leaving empty office space), and will cut inventories (reducing their need for warehousing). This adds up to lower demand for commercial properties, and hence lower prices in the future.
Of course, it’s not all bad. Lower commercial property prices would reduce business rents, which would be good for businesses and their customers, helping to offset lower sales due to uncertainty and higher import prices from the falling pound.
And there are opportunities here for new providers to enter the market. Perhaps community co-operatives could take advantage of lower commercial property prices to buy facilities for community use. After all, commercial property is not just an investment: it has a real social purpose. Losses for investors may be gains for society as a whole.