I don't like to post blogs twice in one day but on occasion it is pertinent. There is a lot of fuss in the UK at the moment about open-ended property funds stopping redemptions. It is being billed as a consequence of Brexit. The desire to withdraw from exposure to commercial property in the UK is a consequence of Brexit and not entirely illogical. There is some uncertainty as to continued demand for UK commercial property space in this environment. However, the closing of the these funds to redemptions is nothing to do with Brexit. It has to do with the inappropriate fund structure. The assets are physical buildings and open-ended means you can cash your chips at anytime. If a lot of people want to cash out quickly it is not hard to see why this creates a problem. Closed-end property funds have moved to a discount to net asset value but you can sell your holdings, albeit at lower price. Open-ended funds should never be used as collective investment vehicles for illiquid assets.< /p>
The closing of these funds to redemptions is not a bad sign but necessary to avoid a real crisis emerging, namely a crisis of market failure. I have written extensively about market failure on my WordPress blog, e.g. Market failure and mark-to-market: anatomy of crisis ,as it is central to financial crises. In brief, it is a situation that arises when people desperately wish to trade but no one wants take the other side. The effort to do so drives prices to extremes triggering more requirements to trade. The problem is everyone wants to do the same thing! The first such failure that I observed at first hand was infamous October 1987 stock market crash. Everyone now knows that prices of stocks fell vertically because suddenly everyone was a seller and no one a buyer (I will not bore you with why). What many do not realise was that bond markets also failed as a consequence, but in reverse. Everyone wanted to buy but no one wanted to sell and even if they did wish to sell they were not necessarily allowed to do so. In such circumstances counterparty risk becomes a priority. All over-the-counter trades involve the risk that the party you just dealt with fails before the trade is consummated. So instructions go out to reduce counterparty risk and not add. This just exacerbates the problem and the market fails. Trading is usually still possible on derivative exchanges because the counterparty is the exchange but this can get a bit difficult as well. The problem of extreme prices is that balance sheets are marked-to-market and, whilst no one can actually trade at these prices, the balance sheets are valued as if they could, and before you know it insolvency appears everywhere. You have a financial crisis.
If these open-ended property funds are not closed to redemptions then the funds will have to put their properties on the market and get a quick sale. They will all be doing this at the same time and for the same reason; Brexit uncertainty. So to whom do you imagine they would be selling and at what price? Extreme price falls would emerge with few actual sales taking place. Now what happens if these prices are then used to value the balance sheets of banks. What provision would you recommend for possible non-performing mortgages in these circumstances? You see where this can lead? Before you know it we have another banking crisis which spreads everywhere like a virus. The problem is everyone wanting to exit UK commercial property at once. Stopping redemptions from open-ended property funds is not a sign of crisis. It is an effort to stop one emerging. A little thought should also be given to investment holdings of residential properties. These may be the next problem.
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Brexit, Property Funds and Market Failure
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