Shockwaves from the Brexit-triggered earthquake in the UK commercial real estate sector are claiming still more victims. Nine of Britain's top 10 commercial real estate funds have now either marked down their assets to reflect plunging real estate values, or have shut their doors to investor redemptions completely.
Headlines over these funds "pulling up the drawbridge" have led to investor runs on the real estate funds still open, putting more strain on a very illiquid investment sector, and depressing real estate prices further.
Royal London Asset Management, which only serves institutional investors, is the only top 10 real estate fund that has avoided the contagion so far. Of the rest, three have marked down the value of their portfolios but remained open, and six have closed their doors to redemptions.
Laith Khalaf, an analyst at stockbrokers Hargreaves Lansdown, told the BBC after M&G Investments became the third UK commercial real estate fund in two days to pull down the shutters, "The dominoes are starting to fall in the UK commercial property market, as yet another fund locks its doors on the back of outflows precipitated by the Brexit vote. It's probably only a matter of time before we see other funds follow suit."
There have been warnings long before June 23rd of the real estate market being overvalued, but it was the surprise Brexit vote to leave the European Union that smashed prices. This led to several real estate funds almost immediately marking down the value of their holdings by an average of 5%.
Speculation has run rampant on how many businesses will relocate from London to mainland Europe, and how hard the economic downturn will be in a post-EU Britain. This is affecting commercial property values, from London high rises to Scottish shopping centers. The Financial Times reported that £650 million in commercial real estate deals had been canceled in the first week after the Brexit vote. By some estimates, London office values could fall as much as 20% in the first three years after Brexit.
This isn't the first time the UK commercial real estate sector has seen a panic like this. During the 2009 global financial crisis, commercial real estate funds were also hit by a wave of redemptions during a price crash. The resulting forced sales of properties into a falling market helped crater real estate prices by more than 40%.
Mom and Pop Hit The Exits
From 2012 to 2014, the UK commercial real estate market grew by 20%. Buying shares of funds invested into commercial real estate was the easiest way for the "little guy" to get in on the action. Now that everyone at once wants their money, people are getting a real-life lesson in liquidity, and the lack thereof.
Illiquidity Breeds Fear
Real estate is possibly the most illiquid asset the ordinary person will see. Even when a ready buyer is found, the financing and paperwork can easily takes several weeks, or even months. At the start of a panic, real estate funds quickly burn through the 10%-20% of ready cash they keep on hand to honor redemptions. When that money runs out, properties have to be sold.
Forcing through an immediate sale would mean accepting a price far below fair value, meaning the fund would have to mark down shares still outstanding. This in effect penalizes those investors who do NOT cash in first, because the total value of the fund is less than it would be if the properties have sold at full price. This is where the fear begins.
When people start seeing a bunch of other people redeeming their shares, they begin to worry that they will be left holding the bag if the fund fails. Much like the bank runs of old, this feeds upon itself until the crowd's demand for their money all at once destroys the institution.
“It’s reminiscent of Bear Stearns’ subprime funds before the Lehman debacle,” Bill Gross, a fund manager at Janus Capital Group Inc., said on Bloomberg TV. “The system doesn’t allow liquidity to flow into the proper places.”
Coping With Disaster
Retail funds, including all seven which have suspended trading, normally revalue their portfolios once a month. However, the value of their assets are now dropping on an almost daily basis. This has led many funds to start revaluing their portfolios once a week, so they aren't caught out by having outstanding shares worth more than the assets under management.
Funds aimed at institutional investors have not seen the panic selling that the retail funds have. This is partially due to institutional investors do not spook as easily as the "man on the street." Another factor is that this type of fund typically only allows redemptions on a monthly or quarterly basis.
Financial Crisis, or Crisis of Confidence?
With banks all across Europe seemingly on the brink of failure, and Britain's economy in turmoil over Brexit uncertainties, it only seems logical that investors want out of a commercial real estate market that's on the skids.
There are some experts though, that feel the situation has been overblown. Fund director Philip Nell, who coincidentally used to manage Aviva, called the current investor runs on commercial real estate investment funds "a massive over-reaction." He notes that, while commercial property values will certainly go down, liquidity concerns have fed a "fear factor" among retail investors.
While some experts expect that interest rate cuts and other stimulus from the Bank of England will stave off disaster, the Bank of England itself has flagged commercial real estate as a key risk to the UK economy since the Brexit vote. The BBC notes that in the first quarter of 2016, far before the Brexit vote, foreign investment in British commercial real estate had fallen by half.
That said, the central bank has moved to inject liquidity into the commercial banking sector to combat the ongoing downturn. Firstly, it reduced the amount of money banks need to keep in their "crisis funds" by £150 billion. It has also signaled a cut in benchmark interest rates could occur as soon as this summer, and even hinted at restarting its quantitative easing program.
Bank of England chief Mark Carney's proactive approach to the UK's worsening economic situation has been met by cheers in some sectors, and warnings from others. But the question remains of whether any man, even a central banker, can buffer the unprecedented shock now being suffered by the British economy.
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