PROPERTY HAS AN OPEN-ENDED PROBLEM / THE WALL STREET JOURNAL

Property Has an Open-Ended Problem

After years of low interest rates, open-ended real-estate funds have grown uncomfortably large

By Carol Ryan

Low interest rates made it more appealing for retail and institutional investors to increase their exposure to real estate./ PHOTO: SAUL LOEB/AGENCE FRANCE-PRESSE/GETTY IMAGES

An old design flaw in the commercial real-estate industry is back, and this time it is bigger and broader.

Property investment funds have ballooned in size since the 2008 global financial crisis, and not just in the U.S. 

According to the European Central Bank, eurozone real-estate funds had assets under management of 1.04 trillion euros at the end of 2022, equivalent to $1.14 trillion and up from €200 billion in 2007. 

Some 80% of these funds by value are open-ended, giving investors the option to cash out daily, weekly or quarterly.

Funds helped the real-estate industry to reduce its reliance on bank loans, which dried up for a while after 2008. 

Low interest rates also boosted property values and made it more appealing for retail and institutional investors to increase their exposure to real estate. 

“A big reason for this is a push by asset managers into alternative strategies,” said Rich Hill, head of real-estate strategy at Cohen & Steers.

But the funds are badly designed for downturns, when more investors ask for their money back. 

Managers may be forced to restrict withdrawals until they can raise cash by selling real estate. 

This is a problem in the U.K. especially, where several funds including ones managed by BlackRock and Schroders have been “gated” since last year. 

It is a recurring pattern: Britain’s open-ended property funds have restricted redemptions four times since 2008.

The ECB is worried that these funds have become so big that they could have “systemic implications” for commercial real-estate markets. 

They now own 40% of commercial property in the eurozone, double the level seen a decade ago—although some of this exposure is through debt or equity holdings rather than direct ownership of buildings.

Forced sales by these important players would put further pressure on property valuations, with knock-on effects for the health of the commercial real-estate loans on banks’ books.

So far, investors aren’t pulling their money in big numbers, but poor returns could change this. 

Listed real-estate stocks are down 36% on average over the past year, according to the MSCI Europe Real Estate Index, but the correction at private funds happens more slowly and is only beginning.

Some regulators have already tightened rules about how quickly investors can get their money back, which should help ease the liquidity mismatch. 

More controls may be needed now that the funds have grown so large, such as charging for withdrawals or asking investors to give longer redemption notice periods. 

This partly defeats the point of a fund that is supposed to be easy to cash out of.

The appeal of these products has taken a hit recently, especially since high-profile names such as Blackstone-managed Breit in the U.S. limited redemptions. 

As interest rates rise, better returns may be available elsewhere with less risk of being trapped. 

More heat from regulators may soon give investors another reason to stay away.