Like anything in markets when money might be lost, the gating of several UK commercial property funds has caused a certain amount of soul-searching. Broadsheets have published guides for worried retail investors; MPs quizzed Bank of England governor Mark Carney on Tuesday about whether he should have stopped it. Headlines about possible “contagion” abound.
Commercial property (CRE) has always been a volatile sector, prone to doing damage to the financial system. UK “secondary banks” (the predecessors of today’s non-bank lenders) nearly blew up the UK clearing banks through commercial property exposures in 1973.
More recently, CRE lending did plenty of damage to HBOS (and subsequently, Lloyds), to RBS, and to the host of hapless German lenders which fell over themselves before the crisis to lend into UK commercial property. It’s worthwhile, real economy business, but it usually involves high loan-to-values, lumpy, unpredictable performances, and no recourse to underlying business.
Of course, that’s just the debt. The funds which have been gated in the last week have been focused on the equity side of things, where at least they are the beneficiaries of non-recourse lending. The Standard Life fund which was first to impose an investor gate could employ up to 160% leverage.
Real estate funds, whether in the debt or the equity, can’t easily provide daily liquidity. Selling a large commercial building, even at a knock-down price, can easily take six months, and even with a little cash on hand, real estate funds cannot possibly satisfy investors who want to escape en masse.
But if this comes as a shock, perhaps investing in real estate funds is not for you. Nobody should have been parking money they needed in a hurry in an illiquid asset class, irrespective of whether it gave daily liquidity in normal times — and gating investors is exactly what should happen when a fund can’t meet redemptions. The funds built in a liquidity mismatch, which, in normal times, investors profited from. When times are tougher, investors find out about the downsides of this liquidity illusion.
Even if, however, the problems spread to other funds, this is an example of properly functioning markets, not of market failure. If nobody took any risk, nobody should be able to earn a return. A market where no investor is allowed to lose money is no market at all.
In fact, the gating of the funds shows the strength, not the weakness, of market-based financing. Investors in property funds place their capital at risk, knowingly and purposefully.
In a system dominated by banks, however, particularly when they are offering development finance, equity and mezzanine as well as senior debt, you have a problem. Depositors, who can’t be gated without bringing down the system, are funding the same illiquid property assets, wrapped in the cotton blanket of state deposit insurance.
Instead of a timely notification onto a regulated market, a bank in trouble will just pass writedowns through its “other income” reporting line in its next quarterly numbers, or shift untold quantities of assets out of mark-to-market portfolios and into a back book. Problems will be concealed, rather than addressed, as the price for keeping the bank afloat and stabilising the financial system. But, as in the case of the Italian banks, problems can’t be concealed forever.
The strange part is, for politicians and for banking supervisors, it’s investment funds and capital markets that constitute the “shadow banks”, while regulated credit institutions are supposed to be in the light. But whose approach to commercial property seems shadier?