Institutional investors face a challenge when contemplating their real estate investment allocation. They are attracted by the relative outperformance of the asset class, its strong diversification characteristics and its relatively high current return component. They want cross-border exposure for diversification purposes, spurred by both the euro and by domestic real estate markets that are often small and illiquid.
But the listed property sector is relatively small – less than 0.85% of the MSCI Europe index with a market cap of under E35bn. For direct investing, institutional investors who maintain large direct property investment capabilities for their domestic real estate portfolios are reluctant to replicate such teams across the continent, at considerable cost and with little proven ability to source acquisitions and manage resource-intensive assets.
The answer to this dilemma is increasingly found in real estate private equity funds – one of the hottest sectors in European institutional investment. According to data from Oxford Property Consultants (OPC), in 1997 the market featured 13 vehicles with an equity value of approximately €2.3bn; today the institutional market includes at least 110 vehicles with equity of around €32bn. Assuming an average of 62% leverage, this implies an estimated €85bn of ‘firepower’ to be invested in Europe, just on the institutional side. Unlisted vehicles targeted at retail investors account for an additional estimated €90bn, with the German open-ended fund market accounting for about 80% of this total.
Much of this growth comes from ‘opportunity’ funds (many sponsored by US institutions) with 54 vehicles of an average size of just over €1bn. As the sector matures, higher-yielding ‘core’ and ‘core-plus’ vehicles, with lower return targets and lower leverage, also are growing quickly – 58 vehicles in the OPC sample accounting for over €28bn of value. As a whole, the real estate private equity sector in Europe (approximately 425 vehicles) is valued at over €250bn, much larger than the $175bn listed property sector in the US.
With this rapid growth comes an array of new issues. A market that had been characterised by opacity and idiosyncrasy is slowly becoming more transparent and broad guidelines of market practice are beginning to emerge. One important milestone of this development is the establishment of INREV, the European Association for Investors in Non-listed Real Estate Vehicles. INREV, which was formally launched at the IPD conference at Wiesbaden in May, is a fast-growing organisation of investors and other market participants formed to promote greater transparency, accessibility, professionalism and standards of best practice. The outstanding industry response to the formation of INREV confirms the need for a strategic industry organisation composed of leading European investors.
Through its committees, INREV is focusing on a number of key issues facing European real estate private equity. Among these are the availability and quality of market information and data; standards for benchmarking, performance and reporting; best practices of governance; differences and complexities of taxation; and the creation of secondary liquidity. Each represents an important aspect of market development and a critical component of maximum liquidity and transparency. 

Market information and data
Both the real estate sector and the world of non-listed vehicles suffer from sub-optimal market information. Efforts such as that undertaken by OPC, which recently published a study on the sector co-sponsored by Morgan Stanley and Deloitte & Touche, have been relatively few, and simple data such as the number, size and type of available vehicles has been difficult to obtain. INREV is working to create a web-based database of open funds that will include basic details such as style, investment strategy, target size and fee structure, allowing investors to understand what funds are available and therefore to make allocation decisions in a more structured way.

Benchmarking and performance
Performance measurement is one of the more difficult challenges in real estate private equity. In the absence of relevant indices or benchmarks, investors have difficulty setting return targets and performance expectations, except by reference to other asset classes. There is not even consensus regarding the methodology for calculating Internal Rate of Return (IRR), the standard performance metric, or whether IRR is superior to total return as a benchmark. Other open issues include: (i) whether fund sponsors should be focusing on asset level or fund level performance; (ii) whether levered or unlevered returns are more relevant and; (iii) if returns should be calculated gross or net of fees. INREV has established a working group to begin to create an index that can function as a benchmark and define standards for performance measurement – an ambitious effort that could have benefits for investors and fund sponsors alike.

Similarly, issues surrounding investor reporting remain an area of considerable interest throughout private equity. Some funds provide an Excel spreadsheet to their investors once a year, while others issue detailed quarterly reports updating the business plan for each asset in the portfolio. A few funds have even begun circulating their investment committee memoranda to their investors. Some investors want as much data as possible; others take the view that they have invested indirectly in part to avoid having to process raw portfolio data. Even agreement on simple matters such as data fields and formatting would represent real progress. INREV is bringing investors and fund sponsors together with lawyers and accountants to attempt to agree basic guidelines for investor reporting.

The intense focus that public securities markets have seen trained on issues of corporate governance has not escaped the non-listed sector. Investors demand – and funds provide – varying levels of governance, disclosure and investor protection. The most common vehicle for real estate private equity in Europe – the English limited partnership – is almost entirely unregulated, while the second most popular – the Luxembourg fonds commun de placement (FCP) – is closely regulated by the Luxembourg Securities Commission according to a detailed statutory framework. There is little sense in the market of best practice with respect to conflict management, independence, oversight and other key governance topics. One goal of INREV will be to try to identify options for market participants and begin to find consensus in this area.

Tax considerations remain a crucial component of all investment decisions, especially in the context of cross-border investments. The intricacies of national tax policies as they relate to real estate adds further complexity, and the tax optimisation of asset portfolios remains a critical element of any fund manager’s role. Investors, moreover, are being faced with an assortment of different vehicles, each with differing tax implications. INREV will try to help investors faced with funds designed for global fundraising efforts understand specific tax implications. Initially this effort will focus simply on creating a database for information on the differences between national tax regimes as they relate to non-listed real estate vehicles, with the goal of lowering transaction costs. Over time, however, INREV expects to focus on the public policy aspects of taxation by working with EU and national authorities to help create a more tax-efficient regulatory environment.

This is perhaps the most important factor for future growth of the non-listed sector. So long as there remains significant illiquidity in the sector, there will be a natural ceiling to broad market acceptance, given the number of investors for whom liquidity restrictions play a role. In theory, indirect real estate investing should help to mitigate the natural illiquidity of real estate portfolios, but only if a true secondary market in shares in real estate private equity vehicles can develop in Europe. While there are some funds specialising in secondary shares in generalist private equity firms, this is an element of the market that is still in its infancy both in the real estate sector and in Europe more generally, with pricing and volume data extremely scarce. A dedicated INREV committee is working to formulate standardised language that can be included in the documentation of non-listed vehicles that will create optimal liquidity provisions and thereby stimulate a secondary market. Many of the other aspects mentioned above, such as better market information and more standardised reporting, will also help to spur secondary trading.
The continued growth of non-listed real estate vehicles is supported by sound fundamental trends. To move past adolescence into adulthood, however, the sector must address some of the fundamental issues facing institutional investors who are making allocations to indirect real estate. INREV was formed to meet that challenge, with an ambitious work programme that will hopefully benefit investors and the development of the market.
Lee Harriss Roberts is a vice president of Morgan Stanley, a sponsor of INREV. 
For more information see