Liquidity Transformation Risk: An Investigation of German Open-End Real Estate Funds

The German public consider residential property as desirable. In economic terms this is a reasonable wish, since real estate investors gain substantial, relative stable returns from their direct real estate assets due to rental income or the saving of own rental costs in case of owner-occupied property. Especially in current times of historical low interest rates, an investment in direct real estate seems to be even more favorable, when comparing real estate returns to capital market returns. Real estate asset returns are also considered to show less volatility compared to stocks. The stock market‘s volatility is one reason for the common German mistrust in the secondary market. Nevertheless, direct real estate investments also exhibit considerable risks. For most private investors the purchase of a house or an apartment is a one-in-a-lifetime decision. These investors get into debt to purchase real estate to an extent, which exceed their current overall fortune. This considerable lot size risk is especially true for direct real estate investments in Germany‘s “Big 7” cities, which show a tremendous increase in real estate prices in the last decade. Moreover, due to large lot sizes, the construction of a diversified direct real estate portfolio for private investors is unfeasible. Therefore, direct real estate investments additionally contain a considerable cluster risk. One preferable investment opportunity for German investors, which are not willing to participate in the stock market, and seek to avoid the addressed risks of direct real estate are German open-end real estate funds. Moreover, German open-end real estate funds also provide a liquidity transformation for investors. Nonetheless, this provided liquidity transformation bear the risk of a fund closure. In succession of the global financial crisis, starting in October 2008, ten open-end real estate retail funds, which represent 25% to 30% of the entire asset class, had to close due to liquidity squeezes. Later on, these funds were also forced to liquidate their real estate portfolio. This situation lead to a never seen before fund crisis, and creates large uncertainty. This thesis is designed to reduce the uncertainty of all market participants about an investment in German open-end real estate funds, and especially about the funds liquidation process. Accounting for the past helps to lower current uncertainty and, therefore, lead to a more stable market environment in case of future fund crises. This task is of special importance for German real estate retail investors, since these investors highly favor low volatility. The present thesis is divided into three single studies (Chapter 2 to Chapter 4), which focus respectively on specific topics associated with the German open-end real estate fund crisis. At first, it is of particular interest to derive the determinants of fund closures to answer the question why some funds were forced to close in succession of the global financial crisis, while others, which are exposed to the same market environment, remain unaffected. It becomes apparent that funds capital inflows, as well as larger liquidity ratios diminish fund closure probability. Moreover, funds immanent economies of scale and scope also show a decreasing effect on fund closure risk. In contrast, external spillover effects caused by other open-end real estate fund closures, as well as a greater share of institutional fund investors increase a funds closure probability. A further step to diminish investors uncertainty, is to analyze the influential factors on fund performance, and the secondary market conditions, especially for distressed fund shares. It shows that emerging discounts to net asset value (NAV) on the secondary market for distressed funds, decrease fund performance due to fund managements loss in bargaining power in the selling process and due to pressure from current fund investors. These discounts to NAV are also a measure for the level of investors uncertainty about the liquidation process in general, as well as about the current real estate asset valuation.Beside the influence on fund closure risk, funds economies of scale and scope also positively affects fund performance. Since, the discount to NAV play a key role to work through this open-end fund crisis, it is reasonable to analyze, at last, which internal (i.e., fund-specific) and external factors influence the price reduction for fund shares on the secondary market. It became apparent that funds leverage ratio increase discounts to NAV, while a large liquidity ratio diminish them. Moreover, the discount to NAV depends on conflicts of interest between current fund investors and fund management. Besides these fund-specific factors, NAV discounts are also driven by spillover effects from the announcement of other fund liquidations, and by investor sentiment. This sentiment influence is proxied by the aggregate level of overall capital flows into the fund industry and by the degree of macroeconomic uncertainty. Summarizing, all considered topics, which are associated with the German open-end real estate fund crisis, exhibit a significant influence of external, predominantly uncertainty related,factors

The Discount to NAV of distressed German open ended real estate funds

The German open-ended real estate fund industry was strongly hit by massive outflows in the course of the global financial crisis. In total, 18 public and institutional real estate funds had to stop the redemption of shares and were ultimately forced to liquidate their portfolios. Investors of these funds either have to await the stepwise liquidation of the funds` assets, which can take up to several years, or they can opt to sell their shares on the secondary market, often at a substantial discount to the Net Asset Value (NAV Spread). This paper attempts to explain the NAV Spread of distressed German public open-ended real estate funds. The unique monthly dataset contains fund specifics and macroeconomic indicators for the entire relevant period. Fundamentals like the leverage ratio and the liquidity ratio as well as industry-wide spillover effects from fund closures affect the NAV Spread. Moreover, we detect a considerably influence of macroeconomic uncertainty explaining the discount to NAV

The discount to NAV of distressed open-end real estate funds

This paper examines the discount to NAV in the context of distressed German open-end real estate funds. This is a unique setting to study NAV discounts because distressed real estate funds are forced to sell off their property portfolios and pay out the proceeds to investors. In contrast, the discount to NAV of closed-end funds or REITs can theoretically persist forever. This enables us to study how investors price the risks associated with the forced liquidation of direct-property portfolios. Our hand-collected dataset covers the complete crisis and post-crisis period from October 2008 through June 2016. Using panel regression methods, we find that the discount to NAV is driven by fundamental risk because it is positively correlated with a fund’s leverage ratio and it decreases with the share of liquid assets. We also provide evidence that the discount is related to conflicts of interest between investors and fund management. Besides these fund-specific factors, we find that NAV discounts are driven by spillover effects from the announcement of other funds’ liquidations, as well as by investor sentiment, which is proxied by the aggregate level of capital flows into the industry and by the degree of macroeconomic uncertainty

Fund closure risks of open-end real estate funds

Over the past decades, numerous open-end real estate funds (OEREFs) in several countries became unable to maintain the liquidity provision and had to suspend the redemption of fund shares. This paper examines OEREF closures in Germany, the world’s largest OEREF market. We find that funds with a larger share of institutional investors had a higher closure probability. This is consistent with the assertion that well-informed investors are able to move more quickly and decisively and therefore trigger additional selling pressure in times of financial turmoil. In contrast, economies of scope appear to prevent closures. In detail, older funds and those sold through physical bank branch networks are less likely to close. Among the factors beyond the control of fund managers are negative spillover-effects resulting from closures of other OEREFs

Fund Closure Risks of Open-end Real Estate Funds

Over the past decades, numerous open-end real estate funds (OEREFs) in several countries became unable to maintain the liquidity provision and had to suspend the redemption of fund shares. This paper examines OEREF closures in Germany, the world’s largest OEREF market. We find that funds with a larger share of institutional investors had a higher closure probability. This is consistent with the assertion that well-informed investors are able to move more quickly and decisively and therefore trigger additional selling pressure in times of financial turmoil. In contrast, economies of scope appear to prevent closures. In detail, older funds and those sold through physical bank branch networks are less likely to close. Among the factors beyond the control of fund managers are negative spillover-effects resulting from closures of other OEREFs

The Discount to NAV of distressed German open-ended real estate funds

The German open-ended real estate fund industry was strongly hit by massive out flows in the course of the global financial crisis. In total, 18 public and institutional real estate funds had to stop the redemption of shares and were ultimately forced to liquidate their portfolios. Investors of these funds either have to await the stepwise liquidation of the funds' assets, which can take up to several years, or they can opt to sell their shares on the secondary market, often at a substantial discount to the Net Asset Value (NAV Spread). This paper attempts to explain the NAV Spread of distressed German public open-ended real estate funds. The unique monthly dataset contains fund specifics and macroeconomic indicators for the entire relevant period. Fundamentals like the leverage ratio and the liquidity ratio as well as industry-wide spillover effects from fund closures affect the NAV Spread. Moreover, we detect a considerably influence of macroeconomic uncertainty explaining the discount to NAV