Expanding the secondary market
Recent years have seen a major upswing in real estate fund investment. The reasons behind the success of these funds are widely known, and the medium-term outlook for demand in this sector appears strong, as institutional investors still have a huge appetite for investment in indirect real estate.Nonetheless, institutional investors are switching their position from an acquisition-only approach to an asset management approach.
Interests in real estate funds are judged according to quality and performance, and are at the same time assessed according to the current investment strategy.
Some of these investors have opted to sell their holdings in one or more funds to keep in line with their changing investment strategy. These interests are sold on the secondary market for private equity real estate.
New initiatives are at the same time emerging on the demand side of the secondary market. New funds have been structured and investment managers have been mandated to acquire secondary interests in the private equity real estate market. The concept underpinning these funds is that of a sophisticated approach, which facilitates investment at the right time and at the right price to generate greater returns.
The secondary market for private equity real estate is a relatively new phenomenon. Until now, trading in shares of non-listed real estate funds has been very limited, especially in closed-end funds. The reasons for this include:
n Lock-up clauses. Funds on the primary market impose lock-up periods on institutional investors to ensure stability. These clauses provide the fund manager with a fair chance of executing the agreed investment policy during an agreed term.
Furthermore, lock-up clauses-prevent funds from engaging in irresponsible conduct when acquiring assets because institutional investors are free to withdraw committed capital at any time. Many funds are now faced with the expiry of these lock-up periods.
n Lack of maturity. Many funds (and fund managers) have a track record of only a few years for investing in and managing real estate. Commitments have not been fully realised and the fund has had insufficient time to prove itself. Investors are convinced that real estate investment is a long-term business and will delay the decision to sell their interest.
n Acquisition approach. Hundreds of real estate funds have been introduced in recent years and existing funds have issued new shares. Institutional investors have focussed on acquisition to gain entry to the best performing funds
n Complexity and lack of experience. The selling process in the secondary market is complex and time consuming. Furthermore, it is an emerging market in which there is a lack of experience on both the selling and the buying side.
The asset management approach has intensified the hold/sell analysis undertaken by the real estate departments of institutional investors. As mentioned, the decision to sell a holding in a fund is not solely financially driven; it can be based on strategic arguments.
Some institutional investors have decided to reallocate their interests from domestic real estate funds to those with a greater international focus, due to a domestic bias in their portfolio.
Other investors have reason to consider divestments because their interests are too heavily allocated in offices or opportunistic funds. This asset management approach of investors will lead to an increasing supply in the secondary market for private equity real estate. What must investors deal with when considering divestments and trading on the secondary market? Due to a lack of transparency, the potential buyer and seller require information to execute a transaction. The fund manager's collaboration in disclosing all the relevant information is a crucial factor for a successful trade. Indeed, the availability of information is one of the distinctive elements between the primary market and the secondary market.
The primary market makes use of information memoranda in which one can find all relevant information in a systematic way, while the availability of information in the secondary market is structured more haphazardly. The most recent annual report of the fund is often the only document which can serve to increase the interest of a potential buyer.
To encourage and simplify trades in the secondary market, INREV has developed guidelines describing how to deal with such processes. The guidelines describe a code of conduct and provide a list of information that should be quickly disclosed after the seller and the potential buyer have entered into negotiations.
Some work is still required to improve the future liquidity of the secondary market. One challenge faced by investors is to act in accordance with a fund's laws and bylaws.
Articles of association include (sometimes understandable) limitations on selling an interest in a fund, and do not encourage the disposal of a holding in a fund. Clauses are in place which stipulate the minimum price of the shares, a right of first refusal to existing shareholders or a general right of shareholders to withhold their approval to a proposed trade.
We believe that to make the secondary market more liquid (and to increase the viability of an asset management approach), this set of laws should be reviewed so they not only protect shareholders rights but also encourage and simplify trade in these shares. This also applies for limitations due to tax regulations, although these external factors cannot be solved by the real estate industry itself.
The secondary market of non-listed real estate funds is an emerging market that is still limited in size. In the coming years it can be expected to increase in size and liquidity.
This is a positive development for all stakeholders in the real estate industry and will strengthen the position of the real estate industry within the financial industry, as well as providing institutional investors with more and better exit opportunities than ever before.