Progress or straitjacket?
The globalisation of capital flows and the high volume of capital targeting real estate over the past few years have accelerated innovation in Europe’s real estate capital markets. These markets are becoming highly sophisticated, and the private property vehicles that have been created to accommodate this capital are now more numerous, complex and diverse.
Exhibit 1 suggests that the gross asset value of non-listed real estate vehicles has risen by 50% over the past five years, with more funds pursuing strategies at the upper end of the risk-return spectrum. This proliferation benefits investors because investment objectives can be better matched to available funds.
With the proliferation and increased sophistication of funds has come greater emphasis on the need to categorise funds according to their investment style. This would provide investors with a better framework for portfolio construction and performance benchmarking and consultants with a means of simplifying the manager selection processes. It could enhance the transparency of the unlisted real estate sector and increase the efficiency of the allocation process.
The industry - in Europe and globally - seems to be working towards a consensus on three style categories for private real estate investing: core, value-added and opportunistic. These labels have existed for many years, but only recently have people sought precise definitions. INREV, whch is leading the drive for greater transparency in Europe’s unlisted vehicles sector, was among the first (Exhibit 2).
In INREV’s December 2006 definitions paper, a fund is defined as core, for example, if its assets provide stable income returns that are a key element of total return; the overall annual target rate of return, after fees and taxes, is up to 11.5% or its target return after fees and taxes is less than 1% above a specified property peer group; and its gearing ratio is below 60% of gross asset value. With the exception of the upper limit of 11.5%, now being reviewed by INREV and likely to be lowered to reflect current market conditions, few investors and managers would disagree that core funds satisfy these criteria.
Without clearly defined boundaries for the three investment styles, some argue that it is challenging to compare the risk and return characteristics of different funds. The difficulty, however, is that many different property- and fund-level risks are summarised in these terms, including the risks of property, portfolio diversification, ownership, financial engineering and tax structuring. As the fund landscape becomes more sophisticated to provide investors with products that better meet their objectives, the risk-return spectrum is becoming less discrete and more of a continuum.
Many investors would acknowledge that a fund dominated by a large, well-diversified portfolio generating a stable income stream should be defined as core, even if a large share of the fund’s capital (say 20%) is in value-added or opportunistic projects. What proportion of capital dedicated to higher-returning strategies is needed for this fund to be called value-added rather than core? Into what category should a large fund fall that is well diversified across the main property types if it has a large share (say 30%) of self-storage or hotels, which are both viewed as more opportunistic in Europe? Would investors’ categorisation of funds differ according to how the ownership of non-core assets is structured and the degree of exposure to operational risk? After all, investment in both asset classes can be structured to look more like core than opportunistic.
Moreover, the characteristics of these opportunistic property types might be accretive to the portfolio, allowing a core-type return with lower portfolio-level risk. This may encourage investors to describe the fund as core even though it has a significant holding of opportunistic assets. The implication is that investors and managers may hold different views on appropriate style classification.
At the fund level, higher gearing ratios are typically associated with greater risk and higher potential returns. In the US, funds with gearing of more than 45% tend to be classified as non-core. INREV’s definition of core limits gearing to 60%, reflecting Europe’s greater tolerance for debt. Besides potentially enhancing returns, debt can increase the diversification potential for a given amount of equity and can also be a tax shield, particularly for multi-jurisdictional investing. However, the optimal capital structure of an investment varies by the type of investment and across the interest rate/yield cycle. Gearing of 60%+ should not automatically push a fund into the value-added box (consider an office building let to the government on a long lease generating a net yield above a long-term fixed cost of debt). Highly gearing this investment could significantly raise returns with limited impact on risk.
Similar blurring exists at the boundary of value-added and opportunistic investing. Furthermore, a manager can alter an asset’s defining attributes (eg, occupancy and quality), so properties held for long periods can migrate between styles. Moreover, a perpetual-life open-end fund could adapt strategy in line with changing market conditions to cause style rotation.
In short, a growing number of funds do not fit neatly into these three style boxes, and investors and consultants are increasingly less likely to be comparing like with like in these categories. Moreover, a fund with risk-return characteristics on the boundary of two styles might be categorised differently by various investors/consultants or indeed excluded from a search simply because it falls between rigidly defined investment styles.
Another potential problem is a drift in the boundaries of investment style over time. For example, to outperform peer group funds, managers may engage in as much higher-returning activity as possible without prompting a reappraisal of the fund style by investors or consultants. The increased use of gearing over the past 10 years, such that ratios of 40-50% are generally acceptable in a core strategy, is perhaps testament to this. Some also argue that were tighter definitions to lead to the formation of a benchmark, management to the benchmark might result, stifling creativity.
Segmenting the private vehicle space to provide investors with an enhanced framework for portfolio construction, performance benchmarking and manager selection will increase transparency. However, as funds become more sophisticated, it is more difficult to force a widening range of styles with multidimensional underlying risks into three boxes. No easy solution exists, but a more detailed segmentation allowing property- and fund-level risks to be separately identified, thus distinguishing between leverage risk, for example, and risk from allocation strategy, property selection and property management, is a reasonable start. This would, of course, imply greater emphasis on property level (ie, unlevered) returns.
David Skinner is head of European research at Pramerica Real Estate Investors