Going to the head of the class
A series of forces are driving new styles of institutional real estate investment. These economic or market forces include the growth in pension fund sizes, the globalisation of business activity, the rapid rise of securitisation, the growth of cross-border performance measurement and innovation in new product creation.
Alongside these forces the traditional features of real estate investment, both positive and negative, to some extent remain. With diversification as the key driver, investors have sought direct and (increasingly) indirect property as an efficient investment class.
While institutional property investment in the UK and Europe has traditionally been effected through the segregated or separate account, through which an insurance company or pension fund will invest in property assets which it owns 100%, the scale of investment required to achieve diversification is a tremendous barrier to entry. Due to a shift in attitude towards real estate and improvements in market liquidity, and to the diversification efficiencies which result, indirect property investment vehicles have increased in popularity in recent years. The Netherlands pension fund has been a particular force for change in this direction.
An apparently obvious solution is the use of liquid traded property vehicles in place of the direct asset. Many countries have their own unique vehicles, such as the Australian listed property trust and the US real estate investment trust. These vehicles may have the primary objective of reducing tax, of achieving liquidity or of aligning the interests of the investors and the managers. They may exist to permit co-mingling of investors, or may be special purpose vehicles for the use of one investor acting alone. Their use has multiplied in recent years as a result of the continued search for liquidity and the success of REITs, the increase in cross-border investment activity, often more attractive in a co-mingled format, and the generally more punitive impact of tax on foreign investors.
The success of the real estate investment trust (REIT) in the US has prompted many investors and managers to encourage the creation of a similar quoted, tax transparent product in Europe. However, investing in property shares has tended to deliver performance which is linked to the performance of the stock market and fails to provide the diversification advantages of property. Returns have been very similar as for direct property investment, but for much greater risk. Hence this means of investing in property has become less popular in recent years.
Attention has instead focussed on a variety of other legal structures which are capable of providing a means for investment in domestic or international real estate investment. Private property vehicles (PPVs) include partnerships, unit trusts, private corporate vehicles and other contractual arrangements such as German Spezialfonds. These vehicles have thrived on the traditional feature of real estate as an asset.
On the one hand the lumpiness of the typical core real estate
asset (a central business district (CBD) office building, a shopping centre) is a great barrier to the efficient diversification of specific risk and inhibits liquidity. On the other hand, the valuation-based
performance of real estate, misleading though it may be, protects investors from the unchecked stock market volatility they might
These features explain, first, the reluctance of the vast majority of pension fund investors to commit to the assembly of global or pan-European portfolios of directly held real estate and, second, the limits to pan-European real estate investment through listed property securities such as property company shares. The former, direct route was the 1980s way; the latter, the listed route, was the 1990s way; the route of choice in the new millennium is clearly the unlisted indirect path. This is explained simply. Unlisted co-mingled property funds can allow investors greater diversification of specific risk than the direct route will allow; and the valuation-based performance of these vehicles protects the asset level diversification benefits of real estate.
Hence, while some larger investors choose to invest by assembling portfolios of buildings (segregated portfolios) or by appointing managers to do the same (separate accounts), smaller investors may choose indirect investment in property through the creation of indirect portfolios of property shares or, more likely, by participating in pooled property vehicles. This has led to innovation by real estate investment managers in both vehicle creation and in the promotion of new mandate styles. Unlisted pooled vehicles –as at April 2004 our firm held data on over 500 vehicles with an estimated gross asset value of €350bn – have found it easy to attract investors, but pension funds often lack the internal resources to select vehicles, undertake due diligence, negotiate terms and manage indirect portfolios.
The rise of the segregated indirect mandate is therefore natural and observable in the UK, and will increasingly be seen across Europe. Misleadingly called fund of funds management in the UK, separate accounts of between £20m (e30m) and £150m are naturally drawn into multi-vehicle investments, typically 5-10 core diversified funds, managed by a an investment manager charging an ad valorem fee with rarely a performance element. Rebates may be available for investment in the managers’ own vehicles but usually additional fees are the price of additional manager diversification and reduced specific risk.
A logical progression for this is the true fund of funds vehicle. A manager with several clients looking for discretionary indirect execution may create a diversified vehicle to achieve the same result more efficiently. Growth in these vehicles is to be expected, alongside continued growth in segregated indirect mandates.
However, it would be a mistake to imagine that this is the perfect route to international real estate investment. To some extent, fees are duplicated. To a great extent liquidity is limited and some control may be lost. There are as yet no accepted benchmarks for indirect unlisted performance. Conflicts of interest exist within most managers. Yet most of these problems will find solutions, and the private indirect route will stand alongside direct execution and public securities as a route to real estate investment for several years to come.
Andrew Baum is managing director at Oxford Property Consultants, www.opconsultants.com