Market InsightFundhouse - Investment Clarity
The Arbitrage Problem in UK Property Funds
Published: 20th October 2022
This Article was Written by: Joe Wiggins - Fundhouse
The UK commercial property market is facing a torrid environment. Not only is the economic outlook bleak; but rising interest rates will put significant pressure on borrowers and, almost inevitably, valuations.
To complete this challenging trifecta, there is speculation that the recent LDI tumult will see pension funds look to reduce their exposure to illiquid assets. Against this backdrop, it is unsurprising that the share prices of the largest UK commercial property companies have suffered falls of more than 30% over the past 6 months, whilst discounts to NAV for certain UK property investment trusts have breached 50%. One area of the market, however, has seemingly been immune to this discomfort – open-ended UK commercial property funds have registered only modest losses. Yet rather than showcase the diversification benefits of the funds in this sector, this performance disconnect is exacerbating risk and further highlighting the glaring problems caused by liquidity mismatches.
Although there has been some gating in the open-ended UK commercial property sector, it has not yet become widespread. The risks are increasing, however, that this will become the case. The performance gap between open-ended and closed-ended funds has been caused by the differing pricing methodologies. Open-ended funds trade based on their NAV, which is derived from an independent valuer’s view of the value of the underlying properties (a form of mark to model pricing). Contrastingly, investment trusts trade based on the supply and demand for their shares (marked to market). As the model-based pricing used to calculate NAV moves very slowly, in times of market stress a gulf can appear between the performance of open-ended and closed-ended funds.
We can see this in sharp contrast by comparing the NAV performance of an example open-ended UK commercial property fund with a comparable investment trust. Although on a NAV basis the performance is similar (as we would expect), the actual share price of the investment trust has diverged dramatically – from its own underlying NAV and, therefore, the performance of the open-ended fund also:
This situation creates a major arbitrage problem for open-ended funds. Holders in daily dealing, open-ended funds have the option of selling their units at the prevailing NAV (less spread costs) and then buying into an investment trust at a substantial discount to NAV. Although there will be differences in the underlying holdings and certain structural features (such as the use of leverage); they are still able to move to comparable assets at a substantially lower price. They may even be able to shift between vehicles run by the same fund manager.
Thus, whilst holders of open-ended property funds may feel some short-term benefit from the slow and stale pricing that has insulated portfolios, the performance disconnect greatly increases the probability of problems with outflows and gating.
It is perfectly reasonable to argue that the share price moves in the investment trust sector reflect overly negative sentiment and are detached from the true underlying value of the properties themselves. Whilst this view may indeed have merit, it does not alter the situation that it is possible to buy into analogous assets at a material discount.
Even investors who hold open-ended property funds but are unable or unwilling to own investment trusts will be worried that performance of the listed sector is a prelude to future NAV downgrades in the open-ended space where pricing may be stale. The temptation to exit ahead of this will be strong.
Holding illiquid, non-market priced assets in a daily dealing vehicle is always problematic. The issue is exaggerated if investors can retain exposure to an asset class but move to a more liquid structure which has experienced substantial mark to market losses. The apparent equanimity provided by model-based pricing may simply prove to be the calm before the storm for open-ended property funds.
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