Given the current economic conditions, the close link between investment funds and commercial real estate (CRE) and its consequences for the whole financial sector has let the European Centre Bank (ECB) evaluate the potential risks and consider new policy measures.

According to a recent report from the ECB, real estate investment funds' (REIF) assets under management increased from €0.4 trillion in 2008 to more than $2.0 trillion in 2022. The growth has been driven by low-interest rates, which have led to a search for yield among investors. Investment funds have also benefited from the shift towards non-bank financing. In Europe, the likelihood of contagion to the financial sector appears lower than in other markets, given that European banks’ exposure to CRE is only 6 per cent. In the US, this is as high as 36 per cent for regional banks and 16 per cent for large US banks, according to DWS.

One of the main risks associated with REIFs is their exposure to liquidity risk. They offer investors liquidity through the ability to buy and sell shares. However, in times of market stress or economic downturns, investors may rush to redeem their shares, putting pressure on REIFs to sell assets quickly. This can lead to ‘fire sales’ and a sharp decline in asset prices, potentially amplifying the impact of market stress on financial stability. Another potential risk of REIFs in the CRE market is their contribution to asset price inflation. REIFs' ability to pool capital and invest in large-scale CRE projects can drive up the prices of real estate assets, particularly in prime locations.

To address these concerns, the ECB is considering policy options that aim to reduce the liquidity risk of investment funds and limit the potential spill overs to the financial sector. One option is to introduce liquidity stress tests for investment funds, similar to those applied to banks, to assess their ability to meet redemptions during periods of stress. The stress tests would be based on scenarios that reflect plausible market conditions and would require investment funds to hold sufficient liquidity buffers to meet redemptions.

Another option is to introduce redemption gates and/or redemption fees, which would allow investment funds to temporarily suspend redemptions or impose fees during periods of stress, to prevent a run on the fund. Redemption gates would enable investment funds to maintain orderly liquidation of assets, while redemption fees would discourage investors from redeeming their investments during periods of stress.

The potential repercussions of these policies for investors and CRE are twofold. On the one hand, liquidity stress tests and redemption gates/fees would increase the resilience of investment funds and reduce the likely impacts on the financial sector. This would benefit investors by reducing the risk of losses due to fire sales of assets and would benefit CRE by reducing the risk of sharp price declines. Moreover, investors may become more aware of the liquidity risk associated with investment funds and adjust their investment strategies accordingly, leading to a more balanced allocation of capital.

On the other hand, funds may become more risk-averse and reduce their exposure to illiquid assets such as CRE, leading to a reduction in the supply of financing to the sector. This could result in a slowdown in real estate activity and a potential drop in prices. Moreover, investors may shift their investments towards other assets that are not subject to these policies, such as exchange-traded funds (ETFs) or direct real estate investment, leading to a distortion of market prices and potential concentration risks.

Investors will be keeping a close eye on whatever the ECB decides to do next.

Further information

Contact Lydia Brissy

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