An open-ended fund dilemma
The conservative world of German open-ended real estate funds is in disorder. In the past few months three funds have had to close down temporarily as a result of a lack of liquidity. One of the funds is managed by a subsidiary of Deutsche Bank and is one of the oldest and largest funds in Germany. What happened?
The problem is a result of the financial market environment in connection with developments in the German real estate market. Low interest rates, the fear of a turn in the bond market and the experience that stocks can fall in three successive years have made it quite difficult for German retail and institutional investors in recent years to find attractive investment opportunities.
In this situation they (re)discovered open-ended real estate funds, some of which offered annual returns of more than 4% and a volatility of less than 1%. Thus, real estate funds experienced large amounts of cash inflows from conservative investors. On the other hand, the German real estate market has been one of the worst performers in Europe since the turn of the century. Those funds investing Europe-wide or even worldwide were hardly affected by this development, but some of the older funds hold mainly German assets.
They have found it increasingly difficult to maintain the returns that investors have expected from them. Hence investors have gradually withdrawn their money from some of the funds. This is not a problem as long as the funds have sufficient liquidity. After about one-and-a-half years of net outflows, managers at one of the large funds felt they would run out of liquidity if the situation continued. Why not sell real estate in order to improve fund liquidity? This is where the second problem comes in. In a weak real estate environment, such as that in Germany, there is no guarantee that the values assigned to the investments in the fund reflect market reality.
Therefore the fund decided to close for a few months in order to re-evaluate the fund investments, to possibly sell some assets to improve liquidity and - if necessary - to adjust the fund price to realistic market levels.
This situation made investors increasingly nervous. Two other funds that invest mainly outside Germany had to temporarily close because of panic selling by investors. Although investors have calmed down a bit in the meantime, the jury is still out on whether there is more to come.
Could the German funds have done better? Real estate is illiquid, that is, the transaction cost of buying or selling holdings (including the amount of work involved) is too high to allow continuous trading of real estate assets. There are two ways of improving the liquidity of this asset class: one can securitise real estate portfolios and trade the securities on efficient platforms such as stock markets. This is the way companies are traded almost continuously although they are equally illiquid as real estate.
In the case of real estate a solution along these lines would be REITS. The advantage of this solution is maximum liquidity. The disadvantage is that the price results directly from demand and supply of the securities and hence it does not reflect the fair value of the underlying real estate at every point in time. In other words, there is excess volatility (which limits liquidity in a broader sense, since nobody wants to sell their investment below fair value).
The second way to improve the liquidity of illiquid real estate is to create an investment fund. It collects investors’ money and buys real estate portfolios. The fund promises to take back the fund shares in exchange for cash at any time. This is how the German open-ended real estate fund system works.
In this system, the illiquidity of real estate has two consequences: the liquidity of the system is, by nature, limited since it is based on the expectation that the purchases and sales of fund shares approximately balance at a price determined by factors other than the demand and supply of shares.
If purchases systematically exceed sales - as was the case before the recent events - the funds have more and more cash, since real estate investments cannot be bought as quickly as money flows in. So the funds become a hybrid between a real estate fund and a money market fund. If sales systematically exceed purchases a liquidity crisis can be the result. Because real estate is illiquid and market-determined, auction-like share prices are not accepted as proxy for the fair value of the underlying assets in this system. The value of the real estate investments in the funds is based on regular estimates by experts.
The advantage of this system is that, in the ideal case, the fund price always reflects the fair value of the underlying real estate. There is no excess volatility. The price paid by investors is a limited degree of liquidity. If too many investors want to withdraw their money at the same time, funds have to temporarily close until they have sold some of their real estate holdings.
This is in the nature of things and cannot be changed. An additional - and to a certain degree avoidable - risk is that funds have to close because investors sell their fund shares just because they fear that other investors want to sell. This is a situation that is unnecessary and as unproductive as a run on a bank. There are ways of lowering the probability of its occurrence.
First, the bank behind the fund can provide additional liquidity by buying fund shares from investors in difficult situations. In most cases this has been done several times in the past and it worked. Second, the valuation of the underlying real estate assets has to be realistic, that is, to approximate market prices as closely as possible. Thus investors can be sure that not selling their shares cannot result in a lower return on their investment. It seems that there is still some homework to do in this area.
In particular, the valuation methodology should be very transparent and very conservative. It might also be a good idea to think about the fact that the valuation experts of a fund are paid by the company managing it.
In addition to the German fund system it would certainly
make sense to introduce the second way of organising real estate liquidity: in other words, to establish REITS. This way real estate investors would have more choice.