After repeated suspensions and dismal performance from many open-ended direct property funds, UK investors may benefit from warming up to the potential of better returns, risk diversification and liquidity with real estate securities. 
The beatings continue for direct property fund investors
As the pandemic abates, UK real estate investors are finally getting some relief after being trapped in open-ended direct property funds for more than a year. Back in March 2020, these funds were forced to suspend trading on £11bn in UK customer assets due to their inability to accurately price and trade their property holdings. Now, after months of raising cash and selling assets at depressed prices, these funds are reopening the gates.
This should come as a surprise to no one. Time and again, periods of economic turmoil have exposed the structural flaw of offering the illusory promise of daily liquidity in funds that own illiquid assets. Worse yet, many of these funds have struggled to deliver returns above inflation, with UK direct property funds providing a median real return of just 1.9 per cent over the past decade, or 3.6 per cent in nominal terms.
Many investors appear to have had enough, leading to an exodus of capital from direct property funds despite the prospect of a recovery in real estate fundamentals. However, investors need not abandon the asset class. Based on the data, a better real estate solution is in front of them.
Funds that invest in real estate investment trusts (REITs) and other real estate securities offer potential advantages across three key areas: a) significantly stronger historical returns, b) the ability to diversify risk across many sectors and geographies, and c) daily liquidity in the underlying assets, which has allowed REIT funds to remain fully open for trading even in times of severe economic stress. It’s a solution we believe UK investors can no longer afford to ignore.
A history of strong REIT returns
The recovery in property fundamentals as economies have reopened has led to substantial returns for listed real estate over the past year, largely offsetting the pandemic-induced selloff in early 2020. Over the longer term as well, REITs in the UK and Europe have, on average, outperformed most open-ended UK direct property funds.
For the past decade, European REITs have delivered three times the real return of the median UK direct property fund. As for consistency, European REITs have outperformed the median UK direct property fund in 90 per cent of rolling three-year periods and in 97 per cent of rolling five-year periods.
Investors should also consider that active REIT managers may further enhance potential outcomes through strategic and tactical allocations, as seen above in the 10-year 380 basis-point excess return of the Cohen & Steers SICAV European Real Estate Securities Fund relative to the European REIT index.
The compound effect of this outperformance has been substantial: A £10,000 investment made 10 years ago in the median UK brick-and-mortar open-ended fund would have grown to about £12,000 in inflation-adjusted value, compared with about £17,000 for European REITs.
For income-focused investors, listed real estate has historically delivered comparable yields to direct property investment, with a 10-year average yield of 4.0 per cent and a current 12-month yield of 3.0 per cent, equal to the current-year average yield of the top five UK direct property funds.
Source: Cohen & Steers
Diversifying opportunity and risk
Property funds focused solely on the UK provide access to a relatively limited investment universe and run the risk that the local property market may be richly valued or at an unattractive point in its fundamental cycle. This has been the case recently, as the UK has been in the lower half of European listed property markets over the past decade amid Brexit uncertainty and a sluggish economy.
By broadening a portfolio’s scope with a REIT allocation, investors gain access to property markets with different return profiles and divergent economic and monetary cycles, which could potentially reduce a portfolio’s economic risk.
The REIT market’s size and depth, coupled with the divisibility of owning shares rather than a whole building, mean that funds investing in real estate securities can achieve much greater geographic and sector diversification than traditional direct property funds. For investors concerned about currency risk, some REIT managers offer hedged share classes.
Investing in new alternative sectors
If investors are going to allocate to the UK, we believe they should own some of the country’s best opportunities, such as self-storage, industrial, health care and student housing. Alternative property types are well represented in the European REIT market, whereas most direct property funds have significant exposure to secularly challenged office and retail assets.
A REIT portfolio may also include digital infrastructure property, such as cell towers and data centres. Alternative sectors have been important contributors to the growth of the UK and European real estate markets over the past decade, and we expect the success of focused sectors will lead to further specialisation.
Source: Cohen & Steers
Daily liquidity
Throughout the pandemic, Cohen & Steers real estate securities funds, like other REIT funds, remained open for trading despite extreme uncertainty about how global quarantines would affect property values. Our funds also remained open during the Brexit referendum, the European debt crisis, the global financial crisis and every other economic calamity since our founding in 1986.
REIT shares can typically be bought or sold at any time, allowing fund managers to invest new monies with ease and raise cash quickly to meet redemptions. As a result, most REIT funds maintain minimal cash reserves (generally less than 1 per cent of assets) and can offer daily liquidity even under challenging market conditions. This makes REITs ideally suited to the retail investor market and defined-contribution investors, as well as to fund-of-fund and model-portfolio managers who need to rebalance with frequency.
This is a stark difference from direct property funds, which typically maintain high levels of cash (often 10–20 per cent) to fund potential withdrawals. Investors must consider the cost of maintaining these liquidity buffers, both in terms of lost performance potential due to the low returns on cash equivalents, as well as the fee paid to managers for holding cash at the bank. This potential cash drag could become meaningful in the near term, as some direct property funds are building up substantial cash reserves in preparation for lifting trading restrictions.
Rogier Quirijns is head of European real estate at Cohen & Steers. The views above are his own and should not be taken as investment advice.