Prompted by his conversations with AREF Investor Members, in this article, our managing director, Paul Richards, reflects on the concerns they have expressed and how such risks can be mitigated.
Real estate funds are holding relatively high cash allocations.
Is this a risk?
Potentially. This means now is an opportune moment to consider counterparty failure risk – and its high impact if it were to occur – and reflect on whether a fund’s cash levels should be diversified more.
At the time of writing, no UK bank has failed this year. But these are not calm waters. The phrase ‘financial instability’ seems to crop up more frequently in polite conversation.
Cash allocations appear to be historically high
Cash held on deposit or in money market funds is always useful – for capex, paying bills, and so on. But there are a number of reasons for these allocations to creep up to, and persist at, unusually elevated levels.
Moreover, that additional 1% on the base rate in the last six months (part of a remarkable climb from 1% in June 2022 to 4.5% by May 2023) offers portfolio managers unusually attractive returns on their cash in the current market environment.
There are no hard and fast industry rules for a desired level of cash. It is up to each fund management company. Our observations suggest that 3-5% is perhaps a normal level, over the long run for open-ended institutional funds.
But investors have advised us they have recently seen a sufficient number of individual examples of unusually high cash allocations. In some cases, these cash holdings have approached 10% of a fund’s net asset value.
This is causing investors’ concern that potentially their biggest risk of loss is now cash within their property funds – which arises from cash that may not be potentially sufficiently risk mitigated or diversified.
High cash allocations with these characteristics may bring problems in the event of a counterparty default.
In praise of diversification
One issue in the financial crisis was that collapsing banks took funds’ cash deposits with them. Partial recovery proved possible in some cases, but only after lengthy legal processes.
With hindsight, should property portfolio managers have diversified their cash holdings a little more? Are there lessons we could deploy now and in the future?
Definitely.
While counterparty assessment is a matter for internal credit committees, the benefits of diversification across banking counterparties can never be understated, particularly given that further bank collapses cannot be ruled out.
The possible risks being run by high cash allocations, held in single deposit accounts or with custodians, are not limited to individual funds.
While there is no implication of a systemic issue, any bank/counterparty failure and subsequently loss of cash on account, might have severe long term reputational implications for the real estate investment industry as a whole.
Of course, these are tail risks.
And it is to be hoped that the current instability neither continues for a prolonged period, nor worsens. But as with all tail risks, forewarned is forearmed.
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