Commercial property: why investment trusts trump open-ended funds

Research shows a painful disparity between the returns from open-ended investment funds and those from listed investment companies.

Things are looking up for the commercial property market as a whole. As the UK economy has opened up after more than a year of lockdowns, forecasts for the sector have improved, with the IPF All Property sector now expected to deliver a total return of 6.9% in 2022, up from a forecast 4.4% for this year. Taking a five-year view to the end of 2025, the IPF anticipates an annualised return of 5.8%.

That’s good news for investors in bricks and mortar funds. However, there’s a painful disparity between the returns from open-ended investment funds and those from listed investment companies (ICs).

According to a recent report from Investec, the eight ICs it featured achieved a total return of between 4% and 10% (average 5.7%) in the second quarter of 2021. In contrast, the institutional share class of the 10 largest open-ended funds returned between -4.3% and 5%, averaging just 1.7%.

The disparity is evident in long-term total returns too. Investec reports that over 10 years to 30 June, the ICs included in its research produced average returns of 7.1% annualised, while their open-ended comparators returned an average 3.3%.

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The problem for open-ended funds is an enduring one. Property is an illiquid asset, yet these funds have to provide daily dealing and sell underlying assets to meet redemptions. When rattled investors are selling en masse (as they did after the Brexit vote, for instance), property funds may be unable to raise the cash to pay them and have to suspend trading for weeks or months.

As Gavin Haynes, investment consultant at Fairview Consulting, points out, the Financial Conduct Authority has been considering changing the rules as a consequence, with the report on its consultation due soon. Those potential changes are causing further uncertainty for investors.

The fund managers have responded by holding high cash weightings to meet potential redemptions. “However, given that cash provides no return at present, it’s acting as a drag on fund performance,” says Haynes. 

These problems are reflected in a steep decline in total assets across those 10 funds, from £13 billion to £8.7 billion (including an estimated £1.6 billion in cash) in only nine months. Two particularly poorly performing funds - Aegon Property Income and Aviva Investors UK Property – are closing altogether. 

At the same time, the structure of ICs confers several inherent advantages. As Haynes explains: “Liquidity is the key benefit, as they can continue daily dealing even at times of stress due to the closed-ended structure, because they don’t have to sell the underlying properties.”

Investec adds that more generally, this structural ‘distancing’ from the pressures of daily dealing “enables managers to focus on asset management without the distractions of inflows/redemptions, which can be material, and are often sentiment-driven and at the wrong time in the cycle”.

Instead, the share price takes the strain of investor redemptions; indeed, it’s important to recognise that if the discount widens significantly, investors may have to sell at a substantial loss.

A further potential benefit of property ICs is the ability to gear or borrow to invest, which helps to enhance returns in a benign market. By borrowing, managers can capitalise on good opportunities, without having to juggle or sell existing holdings.

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Currently the average gearing (portfolio value relative to net asset value) for direct property ICs is 130%, while the constraints on open-ended funds mean they are just 84% invested on average, according to the Investec report.

However, warns Haynes: “While gearing enhances yield and the highly geared trusts have performed very strongly in a positive climate, it is important that investors understand how gearing can amplify losses when the cycle turns.”

A third benefit highlighted by the report is the superior dividend yield of property ICs, currently averaging 5.2%, compared with 2.5% for the open-ended comparators.

Finally, it’s worth noting that despite the upturn in fundamentals, closed-ended funds are mostly still trading on double-digit discounts to NAV. As of 1 September, only AEW UK of the eight ICs under scrutiny in the report is trading at a small (1.6%) premium.

“If UK commercial real estate performs in line with expectations, or if the closed-ended sector can attract a small proportion of the monies currently leaving the open-ended sector, we see the potential for a further improvement in ratings,” comments Investec.

Haynes agrees that “it is hard to argue the case for open-ended funds that are wholly focused on direct property in the current climate”.

However, he suggests investors looking for property exposure could also consider “a hybrid fund skewed towards property shares but also with a proportion in direct property, such as BMO Property Growth & Income”, or an open-ended property securities fund, many of which also offer an international property element.

For full-blown direct property exposure, he prefers “a plain vanilla closed-ended property trust that doesn’t have too much gearing”. Investec’s core closed-ended choices are Standard Life Investments Property Income (LSE:SLI) and BMO Real Estate Investments (LSE:BREI).

interactive investor favours BMO Commercial Property (LSE:BCPT), which appears on the Super 60 list. Its share price remains below its pre-pandemic sell-off level – it was trading at 108p per share on 21 February 2020 and is currently trading at 96p – but the share price has been climbing over the past six months or so amid expectations that the outlook for property is brightening as lockdown restrictions ease.