CBRE's experts Sami Kiehelä, Head of Capital Markets, Nordics and Finland, and Jussi Niemistö, Head of Research, Finland, share their insights regarding the open-end real estate funds in the Finnish market. This is also relevant for other Nordic markets.
The rise of the open-end real estate fund
Open-end real estate funds have seen a favourable market in Finland in the last years and the market has emerged from a handful of funds 5 years ago to more than 21 funds today. At the same time, total assets under management of these funds have grown from €0.4 billion to €6.2 billion and these funds have become a major player in the commercial real estate investment market in Finland. In 2019, the Finnish open-end fund sector alone invested in total of €1.38 billion worth of real estate, 20% of the total Finnish investment market and 36% of all domestic purchases. In fact, the sector has become the largest domestic investor group in the market. [i]
The appetite for an alternative asset class
Arguably, a long lasting ultra-low interest environment has played a significant role in the genesis of the Finnish open-end real estate fund industry. With a limited number of stock exchange listed real estate companies, these funds with diversified portfolios have also provided Finnish households with an effective means of accessing the commercial real estate market, an alternative for the traditional equity and fixed income products.
However, it is not only households who have invested in these funds – in August 2019, 35% of the fund investors in the Finnish open-end real estate funds were non-households.[ii] This is in line with the international counterparts to the Finnish market. Researchers have discovered that in Germany, where there is a long tradition of open-end real estate funds, institutional investors account for 0 -30% of the fund investors[iii] and often use the open-end real estate funds as a higher yielding alternative to money market funds[iv],[v].
Real estate is a relatively illiquid asset class and investment sizes are often unattainable to a vast majority of investors. Effectively, the open-end real estate funds provide liquidity transformation to their investors by selling and redeeming fund units. However, at the same time, the funds are exposed to liquidity risk as their liabilities are short term - the units can be redeemed typically on quarterly or bi-annually basis – but the assets are by nature long-term.
In order to mitigate the inherent liquidity risk, the open-end funds have several mechanisms to smoothen the potential capital outflows. All funds operating in the Finnish market use a gradually decreasing redemption fee incentives to lengthen holding periods. In addition, the funds can typically temporarily suspend redemptions or postpone them to future redemption dates. Many of the funds have liquidity ratio requirements (liquid assets to total assets) to maintain sufficient liquidity at all times.ii
Are open-end real estate funds recession-proof?
The Finnish open-end real estate fund market has not yet been tested in a downward trending market and it remains to be seen what impact the COVID-19 crisis will have on capital inflows. The ongoing pandemic and the following economic downturn have caused the real estate market fundamentals to deteriorate in an unprecedented speed and scale. Whilst the market change has been far from even across different real estate sectors, the economic uncertainty continues to cast a shadow over the occupier demand in the near future.
As the Finnish open-end real estate fund market yet remains largely untested, it is worth having a look at the German open-end fund market which has experienced two major crises in 2000’s: the German open-end real estate fund crisis in 2005-2006 and the Global Financial Crisis in 2008. During these crises the funds experienced big challenges and liquidity problems as investors rushed for the exit causing large capital outflows and funds were closed to prevent illiquidity.
Academic research has studied the determinants of the capital outflows and fund closures. The funds with the highest share of institutional capital and the lowest liquidity ratio suffered the most severe capital outflows and fund closure risk.iii,iv It is interesting to note that a large share of institutional investors create a blockholder risk which can cause additional selling pressure and deteriorating liquidity ratios.
The Finnish open-end real estate fund industry has not only become a significant part of Finnish commercial real estate investment market but also established its position in the household investors’ portfolios. The market is yet in its early years and has not experienced a significant market dislocation to date.
The ongoing pandemic has caused some discussion regarding the potential liquidity risks involved but no signs of significant capital movements have been seen. In contrast, until recently the strong demand from investors has caused some of the managers to temporarily close their funds for new subscriptions to curb over-liquidity.
However, at times, the open-end real estate funds were held in the public as ‘safe and low-risk’ investments, but the liquidity transformation and inherent fund run, and closure risks are widely dismissed. Experiences from the German market suggest that those funds with the highest share of household investors and liquidity ratios are the most stable in the turbulence.
[i] Data by CBRE Research. Open-end real estate fund refers to a special common fund (in Finnish: Erikoissijoitusrahasto) as provided in the Act on Common Funds that is engaged in direct real estate investments. Bank of Finland statistics show a total of 33 open-end real estate funds, including the funds of funds, at the end of 2019.
[ii] Teema-arvio kiinteistöihin sijoittavien erikoissijoitusrahastojen arvonmäärityskysymyksistä ja likviditeetinhallinnasta, Finanssivalvonta, 19.11.2019
[iii] The Determinants of Real Estate Fund Closures. Schnejdar, Sebastian & Heinrich, Michael & Woltering, René-Ojas & Sebastian, Steffen. (2018). SSRN Electronic Journal. 10.2139/ssrn.3236569.
[iv]The dark and the bright side of liquidity risks: Evidence from open-end real estate funds in Germany. Fecht & Wedow. (2014). Journal of Financial Intermediation. Volume 23, Issue 3, July 2014, Pages 376-399.
[v] Open-End Real Estate Funds in Germany: Genesis and Crisis. Bannier, Christina & Fecht, Falko & Tyrell, Marcel. (2007). Kredit und Kapital. 41. 10.3790/kuk.41.1.9.