The strong emergence and subsequent growth of private funds world-wide has indicated that many see this as a good solution to access cross-border real estate returns. And, indeed for many reasons, private funds are bound to be tomorrow’s ‘commodity format’. For even a moderate allocation, one is able to get access to a diversified portfolio of assets. Volatility of returns is much lower than its listed counterpart. Building up a portfolio does not call for the staffing one has to put in place for a portfolio of direct real estate investments. Finally, the private fund manager has the local expertise and presence to source transactions one is not able to pursue being a foreigner.
However, a number of pitfalls exist. For those institutions that contemplate establishing an allocation to non-listed real estate, here are some thoughts, which hopefully could be of guidance.
After having made the decision to invest in non-listed real estate abroad, the investment staff of institutions is faced with the question of how to realise this allocation. A number of issues need to be addressed.
Firstly, institutions have to deal with the regulatory environment that may affect investment guidelines. For instance, legislation may put a cap on the stake a pension fund is allowed to hold in a fund. Secondly, institutions should think about the risk return targets they want to reach for. Thirdly, in which region (Europe, the Far East or the US) should they be invested, and what would be the level of allocations to any of those? Main drivers for these decisions are diversification, timing of going into a market and risk appetite, not only in relation to country and market risk but also in terms of currency and fiscal risks. The next question is about time horizon: Is the investor able to commit money to a fund that aims for a seven-year life?
A last question involves the ‘investibility’, ie how much time does the investor have in mind to build up a portfolio of investments in funds? Mostly, funds establish a period of three years during which they aim to invest the money committed by investors. Capital calls are issued once transactions are to be completed. This takes time: often institutions find themselves invested for only 60% of their total commitment to funds at the point where the first funds have started to return money (as they in fact should, since they are in the business of making money for their investors!). Over time, more core-funds (albeit with relatively lower risks and returns) will emerge, offering investors exposure to a standing portfolio of assets.
A major feature of the growing number of private real estate funds available is choice. Investors these days are being offered a wide range of products, with varying degrees of risk (amongst others exposure to leverage, development, or leasing risk) accompanying a range of target returns. Today, just in Europe well over 280 funds exist. Funds target different countries and sectors; strategies differ widely and funds may target equity and/or debt products. Country and sector specific funds exist alongside pan-European and global funds.
Once investors have decided in which sectors and regions they want to invest, the selection of the best manager is the next step. Sometimes, one may want to rely on the manager to determine a strategy. Here, the manager often receives a broad mandate to do what suits best. Alternatively, the investor selects those funds that reflect the combination of sectors (products) and markets (countries and regions) it wants to access.
The next important step is the process of due diligence and negotiation, involving a host of factors determining the investors’ comfort level and the assessment of risks of the fund. These include alignment of interest between manager and investors, quality and continuity of management, track record, corporate governance, fiscal structuring, exit strategies, attribution analysis of factors determining the target return and, perhaps finally, the term sheet with fees and costs. All these factors do matter and call for experience in dealing with this asset class.
Benchmarks for direct real estate have increasingly become available, NCREIF offers indices for US real estate, UK-based IPD offers indices in a growing list of European countries. In the not too distant future, we will be able to use a composite index consisting of indices from different European countries to benchmark our pan-European real estate returns.
However, it remains a hazardous task to compare indices based on annual total returns with mostly IRR-driven private funds that, as we have seen above, are not invested from the first day. One of the tasks for the providers of indices is to create a benchmark that reflects the risks private funds incur in meeting their return targets. Assessing and comparing funds with different strategies will remain difficult, certainly in the area of funds with opportunistic strategies where a host of factors may determine the indirect return. Instead maybe we should take a look at the buy-out and venture capital fund industry, where many investors have taken their refuge in peer group benchmarking. Often comparing funds on a vintage year basis, they look for the manager who is a top quartile performer relative to its peers.
Once documents have been signed and the money committed, some investors still think they can put all contracts in the drawer and wait to pick up their capital and proceeds at a later stage. There is a countervailing power at work when investors carry out their due diligence and negotiations for a (better) term sheet. Once the fund has started also some degree of monitoring is warranted.
Advisory boards, as they most often are being called, are a good platform for this. In these bodies, where both the larger investors and the fund manager are represented, normally a host of issues is being dealt with. It first of all is the place where votes are taken on issues already covered by the legal documents. Examples may be decisions on the extension of the investment or holding period of the fund. Also, this is the platform where potential conflicts of interest are discussed (such as disclosure by the manager of related parties transactions).
But maybe more importantly, advisory boards could be a good place where investors, where needed, co-operate with the fund manager solving those issues that arise but were not foreseen. These may be the result of changes in the environment, be it fiscal (a change in legislation) or the broader market environment, affecting the risk return profile of the fund. A second issue one comes across is a fund changing its focus during its life. A fund with a value added strategy may have come to a stage of liquidation, where the fund manager and/or investors have expressed the wish to keep the money invested, hence changing the strategy into that of a core fund. Here, all parties discuss issues like liquidity (for those investors who want to exit) and, potentially, a new fee structure.
Most of these issues cannot be covered and foreseen at the start of the fund, but call for experienced (and vocal!) investors claiming their part of the overall responsibility for the successful final stages of the fund.
In less than a couple of years and from various directions, the industry has geared towards improving its attraction to a wide range of investors. Institutions and increasingly also fund of fund managers will invest in a growing number of private funds. Competition between private funds and also the broader business environment move the industry towards greater transparency. INREV, the European association for Investors in Non-listed Real Estate Vehicles, is working hard towards raising the level of professionalism of the industry: many committees are now at work, amongst others to provide for a better industry benchmark, reporting standards and liquidity for investors. Private fund managers will continuously develop better products for their clients, including more open-ended funds, offering investors exposure to a standing portfolio of assets.
Erwin Stouthamer is director international real estate with Mn Services
in the Netherlands