Betting on the rider not the horse
Question: what do the following have in common? Serviced land; garden centres; airports; bridges; waterside urban regeneration; car parks; hotels; road-rail intermodal facilities; ports; air cargo terminals; truck terminals; military housing; medical offices; senior housing; student accommodation; laboratories; theme parks; drive-through car servicing centres. Answer: they are all institutional property investments; five years ago they would not have been.
The reason for this is familiar to us all: the weight of capital coming into real estate, driving down yields and prospective returns. The search for return, as well as the physical shortage of stock, has driven investors outside the traditional retail-office-industrial into these new sectors.
Money has also been driven across borders. Prospective returns across the whole of Europe are looking pretty similar and European investors are looking as far afield as Asia and South America for higher returns and, implicitly, higher risks. Ironically, as emerging markets in Asia grow wealthier, capital from that region has started coming to Europe in search of lower risk and, implicitly, lower return.
This movement of capital between sectors and countries encounters one obstacle - the new target sectors and locations are outside the “home” skill set of most investors. Most of this capital has therefore gone through specialist funds. Unlisted funds are now the largest investor category in JLL’s Global Capital Flows study.
There are other advantages to unlisted funds. They enable smaller investors to achieve diversification normally only available to the largest investors, and to gain access to larger assets such as shopping centres that would normally be beyond their reach. Investors of all sizes can get access to portfolios of small management-intensive assets.
Finally, there is a more recent factor driving capital into unlisted funds: the search for income growth. For the past few years yield compression has been driving capital growth across most real estate markets. With the end of yield compression in most countries outside the emerging markets, the focus will be on income growth and on those managers who can use their skills to provide it.
But … investing in a fund is different from buying a building, and requires different processes and skills. Property due diligence is not enough. With the exception of funds like the Bluewater LP, where a single asset dominates the fund, in most funds the property portfolio could change completely over the life of the fund, and probably should if managers are doing their job properly. In some cases the fund’s income is derived from the profits of the underlying business rather than from rent - hotel or car park profit-share management contracts are an example. One is therefore primarily investing in management teams, not just the property, and the skills of a private equity investor are more relevant than those of a traditional property investor.
What are the differences then? First, there is a lot less property due diligence. You need to check that you are comfortable with the values of any seed or pipeline properties, but if you find yourself having to second-guess the manager’s own property due diligence, it could be a sign that you actually shouldn’t be investing with them at all. In addition there are areas to be covered that don’t arise in a property purchase, probably falling under five categories: tax; strategy; financing; fees and alignment of interest; and corporate governance.
If tax does not work, the fund will not either. But what works for an investor paying tax in the UK may not work for a Danish or Canadian investor, and sometimes a particular investor type can compromise the tax status of the fund and the other investors.
Second, fund strategy. Being in due diligence implies you are happy with the broad fund strategy. However, it is the definition of the strategy that is important. You need to know that halfway through the fund life, when the management team may have changed, the “diversified high yield” won’t have become a “secondary industrial” fund. Definitions of strategy can be drawn narrowly, particularly for sector specialist funds or, for opportunity funds, the definition can be loose, allowing the manager to invest in almost anything he judges will achieve anticipated returns. The trick is to draw the definitions closely enough to know what you’re getting but loosely enough to allow the manager to do his job.
Thirdly, fees and alignment of interest. It is not just a matter of trying to keep fees as low as possible, but of ensuring that the manager shares risk with the investors, is incentivised to take the right risks, is appropriately rewarded for achieving the fund objectives, and that the investor is receiving value for money. Fees clearly need to reflect prevailing market levels, but probably the most important thing is to make sure that the balance between management fees and performance fees is right. Management fees should be sufficient to allow the manager to make a reasonable profit, with large profits only made through performance fees if target returns are exceeded. The hurdle rate should not be too far away from the stated target returns, or you might start wondering how realistic the target is. Co-investment from the manager is always desirable, at sufficient level to focus the mind, but not so high that the manager’s interests might override those of the investors. The source of the co-investment is important. Capital from the fund management company itself is more meaningful than capital from a well-capitalised parent. It is also important to ask here how key individuals are tied into the fund and rewarded. Fourthly, financing. Debt in place should reflect the best terms available in the market at the time when it was raised, gearing levels and hedging structures should reflect the desired risk profile of the fund, and debt maturity profiles the lives of the assets acting as collateral.
Lastly, corporate governance. The fund constitution needs to put crucial decisions in investors’ hands. These include: removal of the manager; changing the fund’s strategy or making one-off investments outside the defined strategy; changing fees and incentives and; terminating the fund or extending its life.
The optimum governance structure can depend not only on how many investors there are but also who they are. Experienced investors may not want less experienced ones to have a casting vote on crucial decisions and may apply pressure to have voting thresholds moved.
Paul Richards is national director at LaSalle IM