Advisers need to understand how these funds are structured and the way in which valuations are made before recommending them to their clients, says IFP Chartered Champion Keith J Robertson.
As the main asset classes are widely thought to be over-priced and of doubtful value, it is not surprising that many advisers have turned to alternative investments.
One of the hottest tickets has been student accommodation funds. These are sold with a very attractive marketing pitch:
Successive governments have hugely expanded the numbers of university places, aiming for 50% of school-leavers to take a first degree.
The expansion in student numbers has far outstripped available traditional student accommodation places – whether in halls of residence, or privately rented flats and houses in multiple occupation.
Fees for all accommodation tend to rise annually by at least inflation, and often faster, depending on location and facilities offered.
Properties are valued as a multiple of the yield and, as nominal rents increase year-on-year, so does the value of the properties owned by student accommodation funds.
These promises seem to be coming good. Look at the performance charts of student accommodation funds and you can expect a steady slope up to the North-East corner.
Among most reliable
The funds have been among the most reliable and ‘safe’, plodding on through all the turmoil of the last three or four years. And with compound annualised returns close to, or even into, double digits, they are often advertised as more than just plodders.
But hang on – not many investments only ever go up. Index-linked bonds might, although even linkers trade in a liquid market where their price is subject to supply and demand. Index-linked gilts do fall in value from time to time and, over the long term, their ability to generate real returns depends on the relevant index genuinely reflecting the inflation suffered by the holder.
Cash on deposit goes up steadily except that, historically, after-tax returns rarely beat inflation – most cash deposits lose significant value in real terms over time. And in the next banking collapse, don’t bet that all failing banks will be bailed out; remember the compensation limit rules.
Ground rent funds have tended to only go up. But these invest in novel underlying securities – essentially enforceable contracts requiring a leaseholder to pay the freeholder (the fund) a nominal annual ground rent. If a tenant fails to pay they forfeit the lease, which is a strong motivation to keep paying.
Thus, these funds have some of the characteristics of a fixed-income instrument but, not being sensitive to interest rates or the property market, provide a peculiarly stable capital value and fairly predictable cash flows – very attractive when short-term interest rates are low.
In my view, the rationale behind the underlying structure fully justifies the upwards-only character of these funds.
So what about student accommodation funds? Isn’t their structure similar, and hasn’t their price gone up and up for years? Doesn’t that mean they, too, should be safe? No. Don’t be fooled into thinking these are the equivalent of financial perpetual motion machines.
For a start, find out what you actually own by holding such a fund. Essentially, you own a hotel business: buildings that rent out rooms.
True, for most of the year you can expect almost 100% occupancy, and it’s probably true that your room prices can be hiked a bit each year.
Yet, if you are forced to sell, all you have is a building. Commercial property is subject to market cycles, and the value of hotels and hotel companies fall during downturns. So why haven’t student accommodation funds also fallen in recent years?
The answer lies in the valuation methodology: these funds are mark-to-model investments. The fund comprises two economic elements: the physical property and the cash flows coming from rents and property management.
Although the industry does not shout this from the roof-tops, properties can be valued in two distinct ways. Obviously, the price paid in the open market by a willing buyer would be robust.
However, the preferred way is to look at the yield. This is how the professionals do it; it gives much more latitude for subjective views. You calculate the gross yield by dividing the nominal annual rent by the capital value of the property. However, this simple equation can also be used to calculate a nominal rent (by multiplying the property value by the appropriate yield) or the value of the property (by dividing the nominal rent by the assumed yield).
But this methodology leaves massive room for subjective assessment, principally in respect of what should be the ‘correct’ yield factor. Clearly, the lower the value used for yield, the higher the resultant value of the property.
And if, as would be expected in the case of student residences, the nominal rents increase year on year, ipso facto the property value must also increase year on year. This is valuation by ‘mark-to-model’.
Valuation on the basis of what someone might pay you in the real world for your building is ‘mark-to-market’ valuation. Managers usually value student accommodation funds by ‘mark-to-model’ and, so long as they do so, the unit prices must continue to increase forever – unless and until they increase the yield factor, or room rates actually fall. This leads to the disturbing realisation that, apparently, one sector of the property market can be relied upon to always increase in value, no matter that all other property investments may be falling. This is obviously nonsense.
Clues may be found in the prospectuses of such funds. Sometimes the ‘mark-to-model’ valuation methodology is not explicitly stated, and never (in my experience) explained. You will normally see that the valuation is to be verified by a third party – often one of the major accountancy firms.
However, such auditors may be required only to confirm the arithmetic – that the cash flows and accounting are correct and that, applying the model supplied by the managers, the ‘correct’ unit price has been derived.
The auditors are not required to comment on whether they believe the correct (or even necessarily realistic) yield has been applied in the model, or that the outcome valuation need bear any relation to an alternative ‘mark-to-market’ valuation.
There is another clue that valuations should be treated with scepticism and caution. Some funds attract buyers by ‘guaranteeing’ that properties can be bought at a ‘discount’, giving an immediate boost to returns.
A sceptic might feel that this feels like a sleight of hand, and what may actually happen could be along the lines of the fictional example in the box.
The process is apparently legitimate, and auditors must presumably be aware. However, with all investments it is critical that advisers dig down to understand how a fund is structured and works day to day; this is called due diligence.
Sometimes investments go wrong anyhow; this is called normal. Due diligence is not easy, is not taught in the professional investment curriculum and not all risks can be anticipated; this is called a knowledge gap.
Fictional case study
The owner of a student accommodation block wants to sell it. After some hard haggling, a student accommodation fund buys it for, say, £8 million.
Actually, it won’t be the fund itself that buys the property; it will be some other entity, connected to the fund, that buys it for £8 million.
The price is not random; it is reversed engineered. It is bought for the lowest price that will secure the underlying nominal rents which, when the fund’s valuation model is applied (remember, the nominal rents divided by the yield) will result in a capital value of £10 million.
The buyer then sells the property to the fund for £9 million. The actual buyer nets a real profit of £1 million, paid for by the fund. But the fund itself can claim to have purchased the asset at, say, a ‘10% discount’ because, what it actually paid £9 million for is immediately re-valued at £10 million by ‘mark-to-model’ and,
Hey presto! Another 10% gain for the year. Well done, that fund!
What can go wrong?
Important questions to ask of any investment are, ‘What can go wrong? What is the downside?’ In the fictional example given in the box of a student accommodation transaction, suppose that for some reason the fund got into trouble and had to sell its assets. What price would you, as an investor, expect to get for your units? The last price on the monthly factsheet, reflecting the £10 million audited ‘valuation’, or the £8 million the building sold for in the real world?
‘Mark-to-model’ is not bad, or wrong; neither is ‘mark-to-market’. However, if an investment has the apparent characteristic of a steady upward return through all economic and market cycles, it is important that we all understand what we are advising clients to buy.
Not only do some funds have well-understood limited liquidity with possible redemption suspensions, there may be some very nasty valuation surprises lurking if ever there has to be a forced sale of assets.
Keith J Rbertson is managing director of Armstrong Financial and Chartered Champion for London for The Personal Finance Society