Redemptions, investor shifts put pinch on real estate open-end funds

A potent mixture of public market declines and investor sophistication is starting to eat away at open-end real estate fund managers' lunches.

Net inflows into open-end real estate funds dropped 25% to $8 billion in the second quarter from the $10 billion in each of the prior two quarters, said the Investment Company Institute's second quarter report — its most recent. While inflows are up from the second quarter of 2015, net inflows had dropped 16.6% in the third quarter of last year.

What's more, open-end fund managers are seeing their first exit queues — despite the net inflows — since 2010. This is a big change for open-end funds that were the post-crisis darlings when investors tilted their portfolios toward core real estate and lined up to invest.

Redemptions and distributions of funds in the Open End Diversified Core Equity index rose in the second quarter to $12.8 billion, offset by $18.3 billion in contributions on a four-quarter rolling basis, according to data from the National Council of Real Estate Investment Fiduciaries, Chicago. Redemptions and distributions were up 26% from $10.1 billion in the first quarter and up 80% from $7.1 billion in the second quarter of 2015.

“We're in a position where the large majority of funds don't have large incoming queues and many don't have incoming queues at all, and some funds are beginning to form redemption queues to get out,” said Peter Rogers, a Chicago-based senior investment consultant and head of Americas real estate research for consulting firm Willis Towers Watson PLC, Chicago. “We're eagerly awaiting the third-quarter redemption numbers to see if indeed rebalancing or redemptions continue, indicating a bigger shift.”

Managers of open-end funds say some of their investors are moving capital out of their funds to rebalance their overall portfolios as falling public markets push real estate allocations near or over their targets.

“We did see some rebalancing in the first half of 2016,” said Joseph K. Azelby, managing director and CEO, global real assets in the New York office of J.P. Morgan Asset Management. This resulted in outflows from some of JPMAM's open-end funds, but JPMAM executives declined to reveal the exact amount of open-end fund inflows and outflows.

Sources with knowledge of the situation said that in the third quarter J.P. Morgan's $30.6 billion core open-end fund had an exit queue of close to $300 million — but also an entry queue of about $600 million. J.P. Morgan's $3.5 billion value-add open-end fund has no exit queue and an entry queue of about $100 million, the sources said.

“We continue to see solid inflows,” Mr. Azelby said. “We see everything from the traditional pension funds still adding to their core real estate allocations and we still see investors relatively new to the real estate space coming into our (open-end) real estate funds.”

Willis Towers Watson's Mr. Rogers agreed that some of the redemptions are due to rebalancing, but he is keeping an eye on the trend.

The redemption issue comes at a time when investors are seeking more control over their real estate portfolios, a move that is at odds with diversified open-end funds.

In September, TH Real Estate, the new name for the real estate business of TIAA Global Asset Management, transformed its $2 billion U.S. diversified open-end fund into five open-end funds; a diversified open-end fund and four sector-focused sleeves.

TH Real Estate last year launched a set of sector-focused real estate funds in Europe and is considering a similar set for the Asia-Pacific region, said Randy Giraldo, managing director of the U.S. focused open-end funds.

“We heard from existing clients and clients from other products that they are seeking more sector-specific strategies and are moving away from generalist strategies,” Mr. Giraldo said. Investors can invest in the diversified fund or choose the investment mix by using the sector-specific sleeves.

A decade ago there were fewer ways for asset owners to invest in direct real estate. But “since the financial crisis the pendulum has swung sharply from open-end to co-investment and separate accounts,” he said.

At the same time, institutional investors have become more sophisticated. Some are adding staff, while offshore investors are moving from passive investments to joint ventures and establishing their own real estate management offices, Mr. Giraldo said. “This is the result of the slow movement to add sophistication. We wanted to capture that trend by giving investors the ability to allocate across property types as they see fit.”

What's more, several real estate and private equity managers have launched value-added and core-plus open-end funds, which once just boasted mostly core funds. J.P. Morgan, Carlyle Group and Blackstone Group all have non-core open-end funds.

The suspension of trading by seven U.K. retail open-end real estate managers after the Brexit vote, due to lines of investors trying to get out, was a reminder that open-end funds are not always liquid. A number of managers were forced to block redemptions while they sold properties to give investors their money back, noted Jason Yablon, a New York-based senior vice president and global portfolio manager with Cohen & Steers Inc.

This is a lesson that institutional investors also learned in the financial crisis, when many open-end funds established redemption gates to avoid selling properties at one of the lowest points of the real estate market, he said.

Cohen & Steers offers open-end real estate investment trust funds but does not offer open-end funds that own properties directly, Mr. Yablon said. “There is a liquidity mismatch with trying to offer daily liquidity when you own illiquid, direct real estate assets that by their nature don't trade daily.”

Open-end fund “liquidity is never a problem until it's a problem,” quipped Mark Grinis, global real estate private equity leader in the New York office of consulting firm Ernst & Young. “Look at 2008. Look at Brexit. Pick your event. You can't run for the exits at the same time,” he said. “Typically people run to the exit at the same time.”

NCREIF data show the impact of a run for the doors can last for a long time. As a result of the financial crisis, redemptions and distributions outpaced contributions of the ODCE funds on a four-quarter rolling basis for two years — ending in the third quarter of 2010.

U.K. open-end funds are still feeling the impact of Brexit, including continued redemptions, Mr. Grinis said.

Still, the open-end fund universe has grown substantially in the past seven years, Mr. Rogers noted. The number of funds in the NCREIF ODCE index has grown to 24 from 14 in 2009, a nearly 72% increase, he said.

But not all investors favor open-end funds. The real estate portfolio of the New Mexico Educational Retirement Board, Santa Fe, is a combination of REITs and real estate invested in closed-end funds, said Bob Jacksha, chief investment officer of the $11.7 billion pension fund.

So far, New Mexico Educational officials have stayed away from open-end funds due to the queues to get in, Mr. Jacksha said. “Also, the large diversified funds tend to be invested in core assets,” he said. “In our view, core assets are and have been expensive for some time. ... While core assets are traditionally viewed as high quality and thus relatively "safe,' we question that orthodoxy if they are overpriced.”

New Mexico Educational has 7.3% of total fund assets invested in real estate, somewhat over its 7% target allocation, Mr. Jacksha said. Earlier this year, pension officials sold some REITs to rebalance. n