Liquidity Issues with Real Estate Funds
But last week’s run on U.K. property funds revealed just how dangerous commercial real estate funds may be since 37% (9.1 billion pounds) of those assets under management are now frozen according to Bloomberg via Zerohedge.1
These real estate funds, with illiquid holdings such as office buildings and warehouses, typical hold separate reserves in case of above average withdrawal activity by investors. This includes cash but also other highly liquid short-term investments like money market funds and even REITs (real estate investment trusts). But when investors get skittish en masse, these reserves get exhausted very quickly.
Seven British real estate funds, so far, have eaten through their capital reserves and as a consequence have had to halt trading in the funds to meet redemptions. This locks up investor’s money in an attempt to try and sell some underlying securities, but more so to allow for a breather among investors. But the action often makes matters worse.
This fiasco shows just how quickly things can go bad. If you are over-allocated to one asset class (especially an illiquid, highly concentrated one such as real estate) you are asking for trouble. The only asset class we prefer people to be over-allocated to is cash. Adding some inverse exchange traded funds pegged to the housing industry or inverse real estate investment trusts is also a consideration and could act as a nice hedge.
Real Estate Funds and the Financial Sector
When real estate goes bad, financial securities suffer since they are inextricably linked. U.K. banks also have serious contamination risk since they are invested in each others real estate funds. This becomes increasingly worrisome the longer these funds remain frozen. Many U.K. banks are already in serious trouble post-Brexit, with some reconciling reduced banking opportunities with greater Europe. Some even contemplate relocation.
Consequently, the equity prices of all major European banks have been smashed following the Brexit, since the European Union just lost its second largest economy. Deutsche Bank has led the way lower and was even referred to as the world’s most dangerous stock in the world.2 This is partly because that ban is at the center of the EU experiment and can’t be allowed to go under. As a result, it will be raising capital buffers as much as it takes to remain safe. This should dilute its equity value.
Remember, European banks never really recovered following the financial crisis, with banks like Deutsche Bank, Barclays and UBS near, or beneath, financial crisis lows. Others predict Spanish or Irish banks could be the next shoe to drop. They had shown signs of problems relating to real estate a few years back.
The securitization of illiquid securities such as real estate becomes an appealing investment to yield-hungry investors. With interest rates near zero for close to a decade now, these alternative investments (real estate funds in particular) are all the rage, even when investors know the liquidity risks. Institutional investors such as insurance companies and pension funds should consider proactive measures since they are major owners of these types of illiquid, securitized investments.
Hedging Investments in Real Estate Funds
Here are a few ways to reduce risk in the real estate sector. Inverse real estate ETFs are a short-term, tactical hedging tool against real estate exposure. The Short Real Estate ETF, REK, is a single inverse real estate ETF that inversely tracks the Dow Jones U.S. Real Estate Index. The largest component of that index is Simon Properties Group. For bolder hedgers, the UltraShort Real Estate Shares Fund (symbol: SRS) is a double leveraged, inverse ETF that tracks the same index. For more equity and real estate inverse ETFs, please refer to our inverse ETF list.
If you want to reduce exposure to the real estate sector, raising cash is always a great option (unless it’s frozen in a U.K. real estate fund!). Don’t think this can’t happen in the U.S. to our real estate funds. Last August, we saw how certain highly concentrated ETFs were unable to open because shares of individual components were halted for trading. If you are worried about a repeat, you might consider raising cash sooner than later. Don’t be the one left holding the bag (or stuck in a frozen fund).
Short selling is also an option for sophisticated investors, although your losses are theoretically unlimited. Further, the cost of the short is probably high considering the tendency for real estate investments (REITs, homebuilders, banks, etc.) to be higher yielding investments. When you short sell a security and hold it long enough, the borrower owes the dividend and gets added in as a borrowing cost. You won’t be able to short sell securities in an IRA.
You might consider buying put options on real estate stocks or ETFs as a hedge. Just because the U.S. markets are making new highs, doesn’t make them any less dangerous. Please bookmark our site, or follow us on Twitter so you’ll have up to date information on hedging strategies when the markets inevitably start to crumble.
As with most inverse ETFs, the daily reset feature could make the investment unsuitable for investors that can’t monitor the exchange traded fund on a daily basis or are risk-averse. It is primarily for more sophisticated investors that want to express a short-term view. Given that real estate price movements are illiquid, and thus longer-term in nature, an inverse real estate ETF may not hedge well over periods longer than one day and certainly aren’t for a buy and hold investor.