Dec 17, 2024
In October the Financial Markets Authority (FMA) published an addition to its Occasional Paper Series entitled Commercial Real Estate and the Managed Funds Industry (Paper). The Paper represents high-level review by the regulator of how a potentially problematic asset class, commercial real estate (CRE – not to be confused with Climate Reporting Entities), is dealt with by New Zealand-based managed investment scheme (MIS) managers, including KiwiSaver scheme managers.
The Paper is concerned with how MIS managers address the following five specific risks in relation to CRE investment allocations held within their managed funds:
Ten representative MIS managers, including KiwiSaver managers, were interviewed for the purposes of the Paper.
In what follows, we consider the risks listed above as they relate to liquidity risk management (LRM), given that FMA published its updated guidance Liquidity risk management guide (Guide) in April 2024 and that the Paper refers to the Guide as being pertinent to its mode of examination and findings. First though we will consider CRE from the perspective of what it brings to retail managed fund investment portfolios.
CRE is formally classified as an alternative asset in contrast to “vanilla” cash, bonds and shares, despite the fact that CRE-related investments can take on the forms of debt and equity. The classification arises because, in contrast to bonds and shares, which are regarded as financial or “paper” assets, CRE is normally classed, like commodities, with real or physical assets. As real assets, CRE investments are often dubbed “bricks and mortar” to further emphasize their physicality.
According to the Paper, CRE comes in four broadly recognised forms:
As an investment, CRE provides investors with (i) fixed income via recurrent rents collected from leasing to tenants that increases with successive rent reviews and (ii) potential capital growth through rising building values over time. Income and building value are not unrelated, as the more rent a building can earn, the more it is worth to sell, although conversely a fall in rental income can lead to a fall in resale price. With return characteristics that permit growth in both income and capital value, CRE is regarded as a good inflation-hedging asset class.
CRE assets are distinctively “lumpy” in that they are usually medium-to-large scale properties that come with corresponding big price tags. The lumpiness of such assets can make them slow to buy or sell, adding to their liquidity risk. Liquidation to pay out CRE investors who want to exit may not be readily achievable for a variety of reasons. For examples, because not all owners of a property may want to sell where more than one person is involved, or buyers are scarce or reluctant, or financiers have cooled on property lending, or there is something seriously wrong with the building that impairs saleability such as structural engineering faults or failure to comply with safety codes that may require complex and costly remediation or even demolition.
Not every investor can afford to buy CRE outright, which has led to proliferation of collective investment vehicles (CIVs) such as trusts and managed funds set up for the purpose of enabling groups of investors to pool their moneys together and make conjoint CRE purchases. If the CRE investment is unitised within a CIV, whether as shares or units, then that subdivision of ownership interests may address at least in part the liquidity risk concerns that investors can face with lumpy property assets. Investors who want to exit should be able to dispose of their shares or units to a buyer, at least in theory.
The Paper identifies real estate investments trusts (REITs) as the primary CIVs for investment in CRE. Historically, REITs are distinctively American financial products structured to enable multiple investors to benefit from pooling funds together to buy CRE in a manner that closely synthesizes direct investment, functioning akin to a pure property play, including individually apportioning pro rata shared profits and tax benefits arising. A REIT would normally be classified as a single-sector fund in that it would only offer CRE asset class exposure or a specialization thereof, although it might hold some minor cash quantum for liquidity purposes.
REITs do not necessarily translate exactly into other financial or regulatory jurisdictions outside of the United States. It should be noted that CRE trusts and companies listed on the NZX may not be REITs in the true technical sense of the word (see Appendix 1 for the largest CRE listings on the NZX). However, for the sake of convenience and in conformance with the Paper’s terminology, all such entities will be called REITs in this article.
As an asset class, CRE’s investment return characteristics (regular income plus capital growth) recommend it for inclusion within diversified investment portfolios based in part on what it brings in its own right. On an ascending scale, both risk and return of CRE are expected to be higher than for bonds and lower than for shares, helping to smooth out risk and return performance over time.
From a portfolio diversification perspective, CRE investment performance usually demonstrates low correlation with bonds and shares. This low correlation means that CRE’s market value does not always rise or fall at around the same time or to the same degree as either of the other two asset classes. However, at certain times CRE can become fully correlated with either or both of them (for example, when short-term interest rates rise sharply, causing all three asset classes to fall in value more or less simultaneously).
In the REIT format, CRE provides diversification benefits within multi-sector investment portfolios because it introduces bricks and mortar, wrapped up into a CIV structure, into the mix. As noted above, CRE trusts and companies that are listed on the NZX may not be true REITs, possibly due to their overlying corporate structures. If that is the case then the performance of their NZX-listed securities may normally correlate more closely with equities than with CRE, diminishing their diversification benefits within a multi-sector portfolio.
The characteristics of CRE outlined above – intrinsic income and growth, risk and return characteristics sitting between those of bonds and shares, and low correlation with the investment performance of fixed income and equities, recommend it for inclusion within multi-sector managed fund portfolios. Fund managers have responded to these benefits by adding and blending various allocations of CRE into their mixed asset class investment portfolios. The Paper is concerned with this multi-sector managed fund context in its consideration of the risks potentially posed by CRE to investors in New Zealand.
The Paper sets out why FMA has grown concerns over CRE being incorporated as a standard asset in New Zealand managed funds. It cites what is happening with managed funds abroad:
Over the past few decades, CRE has become an increasingly important type of alternative investment for fund managers. Its ability to provide both steady income and growth potential makes it well suited to a diversified investment portfolio. However, interest rate rises and the changing nature of working and shopping have caused major downturns in many overseas CRE markets, with severe refinancing stress and significant falls in asset values. This, combined with the assets’ illiquid nature, has forced some overseas funds to temporarily suspend or limit withdrawals.
(Paper, p. 6)
Under the heading 1.2 What’s going on in the commercial real estate market? (pp. 7-8), the Paper provides analysis of the problems besetting CRE and REITs overseas, with a principle focus on the US market. Plainly there are problems: US-based CRE and REITs are struggling with falling property valuations, growing vacancy rates, low yields, delinquent loans, rising interest rates, and negative equity. As a consequence, some large US REITs have had to place restrictions on the amounts that their investors can withdraw as a proportion of total fund assets or suspend withdrawals outright. However, as noted above, REITs in an American context are single-sector funds with at most low cash allocations and so it does not follow that exactly the same problems will flow across into New Zealand-based managed funds with CRE allocations, unless they have invested into troubled REITs themselves.
Nonetheless, having observed the issues that CRE market turbulence have caused REITs abroad, the regulator became concerned that the same problems might be occurring within its bailiwick. Accordingly it instigated enquiries with selected New Zealand fund managers to establish the facts:
In this context, and after discussions with international financial regulators, the FMA was concerned this may become an issue for the New Zealand managed funds and KiwiSaver industry. Using a combination of desk research and focused interviews with fund managers, this paper examines the exposure of New Zealand investment funds to CRE and how that exposure might impact customers. We also want to understand how fund managers manage the key risks associated with CRE and how they communicate those risks to customers.
(Ibid., p. 6)
As noted above, FMA’s Paper looks at the impacts of CRE in managed fund portfolios under five risk topics. The purpose of this article is to consider how these five risks relating to CRE could impact on LRM requirements as set out in the Guide. Three of the Paper’s risk topics impinge most obviously on LRM as described in the Guide, namely risks concerned with liquidity, valuation, and leverage. However, we shall also give some attention to concentration risk and communication of risks to customers as another potential LRM dimension.
In respect of liquidity risk, the Paper recognises three categories of CRE investments:
Each of these categories presents its own potential challenges to managed fund LRM. The illiquidity of unlisted REITs makes them the most potentially problematic through infrequent trading, potential scarcity of buyers, and irregular or inaccurate valuations. Listed REITs can in theory be sold in share markets within fairly short periods of time and modelled for potential price falls during periods of sustained liquidation. REIT-issued bonds carry particular LRM-related considerations in liquidity, valuation, and default risks.
Of note, however, is that FMA disagrees with the beliefs of some MIS managers that share market listing of REITs is a panacea for LRM purposes. The Paper states:
… in some cases fund managers told us that because these assets are listed, they believe there is no issue around liquidity. We are concerned about this. It is unlikely to be true, especially for funds with sizable holdings in a particular REIT. In reality, it is not always easy to liquidate a high-value position without materially impacting the unit price, even for a listed asset.
(Ibid., p. 11)
The Paper notes that LRM of CRE investments presents special issues for KiwiSaver funds due to legal requirements to be able to transact timely for the purposes of meeting fund-switching requests and early withdrawals for first-home deposits or financial hardship. KiwiSaver managers are also warned to watch carefully their outsourcing of day-to-day management of their CRE portfolios to third-party firms. Such outsourcing entails assuming multiple risks including liquidity, valuation, and key person risks. Ominously the Paper cautions:
We expect firms to manage these risks well and be held accountable for the performance of their third-party portfolio managers. We also recommend that funds put appropriate governance and reporting frameworks in place to maintain good oversight of their investments.
(Ibid.)
Explicit discussion of liquidity risk in the Paper is comparatively brief (pp. 10-12). The risk is interpreted narrowly in the Paper, being treated as exclusive of the other four risks examined therein. Reference is made to fund managers making use of the Guide and its earlier version from 2020 to tailor their LRM practises to CRE holdings in their investment portfolios. Moreover, the discussion is not very granular and where it does address such practices it summarily examines only a few drawn from the Guide’s 11 Features of effective LRM without naming these Features in the process. The Features implied in the Paper’s liquidity risk section are tabulated below:
| Paper topic | Guide Feature |
| Governance | Feature 2 – Governance |
| Illiquid asset definition | Feature 6 – Monitoring framework (Sub-feature 6.3) |
| Stress Testing | Feature 8 – Stress testing |
It could have been a valuable exercise for the Paper’s liquidity risk section to have reported in some detail, for example, on the application of liquidity management tools (LMTs) to CRE investments by the fund managers interviewed. Feature 7 of the Guide sets out the importance and range of LMTs that can be brought to bear upon LRM of managed funds and emphasizes that a “graduated strategy” (Guide, p. 15) is required for the use of LMTs. It is rather surprising that this important aspect of LRM is left out of the Paper’s discussion of liquidity risk, given that it would have added considerable value for CRE-related LMTs to have been studied within it.
The Paper also does not draw specific linkages between the other risk topics it covers and the relevant Features of the Guide. Two of these risks – leverage risk and communication of risks to investors – are explicitly presented as Features in the Guide, as tabulated below:
| Paper topic | Guide Feature |
| Leverage risk | Feature 9 – Use of leverage to adjust risk/return |
| Communication of risks to customers | Feature 4 – Product Design, Feature 5 – Disclosure and communication |
The Paper presents knowledgeable discussion of the risk that leverage, in this case borrowing, imports into REITs, particularly the unlisted variety. The discussion is focused on single-sector REITs, however, and does not consider leverage that can be brought into multi-sector managed funds by their managers borrowing up to any ceilings specified in the governing trust deeds and fund establishment deeds against the assets of these funds. Borrowing at fund level could exacerbate leverage already embedded in underlying CRE or REIT allocations and increase overall liquidity risk in the event of market downturns and/or loss of appetite by lenders to finance borrowing at either fund, CRE, or REIT levels.
Notably, though, the Guide’s Feature 9 does not elaborate much on borrowing leverage, instead devoting most of its commentary on leverage to derivatives. Nonetheless the Feature does specify “traditional balance sheet” leverage as presenting risk that fund managers need to understand, incorporate into LRM policies, and communicate to their investors.
For communication of risks to customers, the Paper and the Guide are complementary but not much similar in their respective discussions. The Guide is quite granular about how liquidity risks are to be disclosed and communicated to investors, whereas the Paper is more concerned with how fund managers assist investors to migrate through lifecycle stages of retirement saving. The Paper does pick out one instance of questionable investor communication practice in a manner consonant with the Guide, where it states:
We remain concerned that, in some cases, fund managers have relatively high levels of CRE exposure in low-risk funds, which are more attractive to customers nearing redemption. We are aware of at least one fund that is marketed to customers over 60 years old that holds a 7.5% allocation in CRE. While we acknowledge that there might be business reasons behind this approach, it is important for funds to appropriately communicate the risks and benefits associated with CRE to their customers.
(Ibid., p. 15)
The other two risks considered by the Paper, being valuation risk and concentration risk, do not fit so obviously under the Features of the Guide. Neither risk is expressly addressed by the Guide, yet both plainly have LRM dimensions. In the case of valuation risk, changes in underlying CRE values may not be accurately reflected in unit pricing of overlying REITs, with unit price discounts or premiums resulting leading to inequitable treatment of investors depending on whether they are buying, selling or holding units in such funds, although this problem would be diluted within the context of a multi-sector managed fund wherein the CRE allocation might be 10% or less. The Paper notes that valuation risk can be overlooked by fund managers as follows:
Trading at an incorrect price disadvantages investors; for example, an incorrect price above the true market value of the underlying assets creates leakage where those investors leaving the fund are receiving too high a proportion of the value of the investments due to the elevated price. Conversely, an incorrect price below the true market value of the underlying assets advantages those remaining in the fund at the expense of those trading out. Because an incorrect price creates a trade-off between an investor selling out of the fund and an investor remaining in the fund but does not directly impact the profit to the fund manager, valuation risk can be inadvertently overlooked by fund managers. The MIS manager valuation and pricing practices (FMA, 2017) include the FMA’s latest recommendations on valuation risk.
(Ibid., p. 12)
In a future revision of the Guide, valuation risk could be incorporated as an explicit Feature or sub-feature of effective LRM, but in the interim there is reference to LRM implications of unit pricing problems under Feature 7 – Liquidity management tools, where, as a quantity-based LMT, an example is given of “temporarily suspending redemptions by suspending net asset value (NAV) calculations” (Guide, p. 15). This LMT could apply in an instance where it was known or suspected that there was a mismatch between REIT unit price and underlying CRE asset values and would apply also to a multi-sector managed fund that had a CRE allocation so affected. Another LMT listed under Feature 7 that would implicitly apply in the same situation would be side pockets, in which special, segregated fund units would be created to hold mispriced assets until their defect could be resolved.
Concentration risk arises with CRE as defined in the Paper:
Concentration risk refers to the potential for excessive loss arising from funds’ large exposure to a single entity or a small number of entities or markets. In the context of CRE, managed funds may be exposed to concentration risks by type of CRE asset, location, market subsector, and similar characteristics.
(Ibid., p. 14)
An example of concentration risk in a New Zealand managed fund context could be a REIT or multi-sector fund that restricted CRE allocations to entities listed on the NZX (see Appendix 1), as that would mean such funds held high and undiversified exposure to New Zealand economic risk in their CRE assets. A downturn in one asset held in concentration with others akin to it could mean a downturn in them all, leading to LRM issues with cross-contamination of assets, unit pricing problems, increased withdrawals, fire selling assets, and treating investors inequitably. Once again, the Feature of the Guide that comes to mind in this instance is Feature 7, concerning LMTs. A revision of the Guide could add concentration risk as another explicit LRM consideration. For consistency with previous analysis, the relationship between the Paper’s valuation and concentration risks and the Guide’s Features can be tabulated as below:
| Paper topic | Guide Feature |
| Valuation risk | Feature 7 – Liquidity management tools |
| Concentration risk | Feature 7 – Liquidity management tools |
The Paper offers many useful insights into liquidity, leverage, investor communication, valuation, and concentration risks as they can apply to CRE, REITs, and multi-sector funds, including KiwiSaver funds. The Paper’s analysis applied to these risks in the case of potentially illiquid assets like CRE and unlisted REITs could be extrapolated to other illiquid assets such as private equity (unlisted companies or venture capital funds).
The Government has expressed a desire for KiwiSaver funds to invest more into New Zealand private equity (NZPE). The considerations raised in the Paper and the features set out in the Guide would substantially apply to NZPE, especially concerning liquidity, valuation and concentration risks. The way in which this article has attempted to marry up the findings and recommendations of the Paper with the features listed in the Guide for the case of CRE can point to ways in which effective LRM for NZPE could be developed, in particular within the context of KiwiSaver multi-sector funds that held asset allocations to NZPE.
“FMA’s new occasional paper on CRE and the managed funds industry opens up lines of thinking as to how the Paper’s findings and recommendations can be used to augment and illuminate LRM,” said Matthew Band, General Manager of Trustees Corporate Supervision at Trustees Executors.
“The Guide published in April 2024 addresses LRM at quite a high, generic level, whereas the Paper by contrast seeks to engage with how risk management should apply to a particular, potentially illiquid asset class, CRE, within the context of New Zealand-domiciled multi-sector funds, including KiwiSaver funds.”
“MIS managers and their Supervisors should be able to gain insights from the Paper as to how they can better perform the LRM-related functions set out for them in the Guide.”
“The Paper does not make explicitly clear how the effective LRM Features of the Guide link up with its findings and recommendations, but as this article has demonstrated, the connections can be teased out and beneficially developed.”
“The way in which the Paper has looked at liquidity, leverage, investor communication, valuation, and concentration risks could be used in any future revision of the Guide to refine its LRM Features, particularly around traditional balance sheet leverage, valuation, and concentration risks.”
“In turn, future FMA occasional papers that examine asset allocations of New Zealand managed funds, including KiwiSaver funds, to illiquid investment sectors like NZPE could take a more fine-grained approach to topics such as actual fund manager practice in designing, implementing, and stress-testing LMTs suitable for LRM of these sectors.”
“More needs to be known and published as to how illiquid assets are to be included safely and subjected to effective LRM within New Zealand managed funds, but especially KiwiSaver funds, given the official preference for greater inclusion of NZPE investments within KiwiSaver schemes.”
“In the interim, the Paper’s expressed scepticism concerning fund manager reliance on listed assets for LRM purposes is noteworthy.”
For comment or more information, or to be added to the free email subscriber list of “The Supervisor”, please contact Matthew Band at [email protected].
The CRE sector listed on the NZX is represented by the S&P/NZX All Real Estate (12 constituents) and S&P/NZX Real Estate Select (8 constituents) indices. These indices contain a number of large capitalisation listings, some of which are Climate Reporting Entities, and only two of which are explicitly identified as trusts: