Risk vs reward
According to INREV, the European Association for Investors in Non-Listed Real Estate Vehicles, the value of the unlisted market has increased from less than €50bn in 1993 to over €250bn in 2003. Institutional investors have played an expanding role in funding this market. How can this be explained?
Since their adverse experience of direct foreign investment in the 1970s, few UK institutional investors (with the notable exception of Standard Life) have been willing to risk getting their fingers burnt again. Direct investment involves considerable risk because of the need to build up big enough holdings to justify the cost of local advice – a risk that few have been willing to take, particularly as the quality of advice can never be guaranteed. Unlisted vehicles have stepped into this breach by sharing out costs and risks amongst the subscribers, while hopefully providing more specialised and efficient management .
Peter Pereira Gray, property portfolio manager for the Wellcome Trust, sees two fundamental reasons for investing in non-listed vehicles: “The first is to gain access to property stock which by nature is too bulky and expensive to invest in directly, and the second is to reap the benefit of specialist management expertise in local markets where Wellcome has little experience – particularly in Continental Europe”. But there is such a wide variety of vehicles available, that it is difficult to generalise about the benefits. Wellcome’s unlisted assets range from a holding in a vehicle which owns three companies, to another vehicle which contains hundreds of industrial units.
Such vehicles also enhance diversification possibilities by giving access to shares of portfolios of assets, thereby reducing the property specific risk associated with 100% holdings of direct properties. This is likely to be especially useful for small investors, and may have the additional advantage of giving access to larger properties than would otherwise be possible.
Kiran Patel, global head of research and strategy for AXA REIM emphasises the diversification benefits of investing in such vehicles. “AXA has a long history of investing in unlisted vehicles, originally as a means of avoiding punitive rates of transfer tax in France. More recently these vehicles have been used as a means of better accessing product in higher returning markets, particularly abroad, managing product more efficiently, and diversifying for risk adjustment. As yet it’s too early to generalise about performance – some funds have done well, some have done badly – but the main emphasis up to now has been on diversification.”
Unlisted funds often use gearing, a facility which is sometimes restricted for the investing institution. This provides the potential not only to widen the pool of property interests acquired, but also the possibility of increasing returns in rising markets, though of course thereby simultaneously raising the risk profile of the investment. And if diversification effects are expected, these will be magnified by the use of gearing.
Nick Mansley, Head of Property Strategy and Research at Morley Fund Management, responsible for life fund interests, asserts that unlisted investments form a “core part” of their strategy, “especially for Continental Europe, either with partners or through vehicles”. They are looking for a mixture of benefits, “ranging from the risk return trade off through overall portfolio diversification to the acquisition of interests in assets not otherwise accessible”.
Mansley adds: “The performance of these assets is however affected by high start up costs in the early years, and there are a number of issues relating to standardisation, for example for legal frameworks and performance fee structures.”
There are other disadvantages of investing in unlisted vehicles. Perhaps most serious is these assets’ lack of liquidity; few vehicles as yet have a well developed secondary market, and most are closed-ended rather than open-ended, meaning that investors are tied in until the end of the contract period, typically five or 10 years. In this respect unlisted vehicles are significantly disadvantaged compared to property shares, and also relative to REIT-type funds and property unit trusts.
Lack of transparency is another serious concern, and results from the lack of information on vehicles’ ongoing investment returns, in contrast to listed funds where price and dividend data are in the public domain. The efforts of INREV to make available general information on unlisted vehicles’ returns are starting to redress the balance, but clearly these will never refer to individual funds unless the managers chose to make them public. There will also be significant differences between the returns on the direct properties actually owned and those accruing to investors, due to the fees charged by managers.
Neil Turner, European Portfolio Manager for the Swedish institution Alecta, doesn’t believe that you have to go down the non-listed route to be international. “Alecta’s preferred business model is still to hold property directly under a good fund manager. It is more difficult to align interests between manager and investor within current fund structures than it is within a separate account.”
Turner says that many investment houses which are also managing for external clients now favour long-term contracts with high operating margins. “Pure investors may not be well served by these arrangements, and the jury is still out as to whether they will achieve the returns they are seeking.” Alecta is also willing to forego some of the potential (often overstated) diversification benefits that unlisted vehicles offer, “so that they can retain full control of their interests and minimise the costs of management”.
Another issue for Turner is the idiosyncratic character of non-listed real estate performance. “Many international real estate allocation strategies assume direct, ungeared returns – these are often then fed into the consultants’ ALM models to justify the allocation to real estate. Highly geared fund structures may not in fact deliver the purity of exposure sought by investors. Some would even argue that they corrupt asset allocation as debt within the vehicles is off-set against the investor’s carefully considered fixed income exposure.”
Should pension or insurance funds wish to invest in the non-listed market, a wide variety of vehicles are available. Of those vehicles covered by the INREV database, worth €187bn at the end of 2003, €138bn are diversified in terms of sector spread, with these dominated by the German open-ended retail funds (total value €91bn). This leaves €49bn or about a quarter by value in 132 smaller sector-specialist vehicles.
Unlisted vehicles’ degree of geographical diversification varies from the broadly pan-European, accounting for nearly one-third of portfolios by value (though only 18 by number), to single country funds with a similar share of value, but a much larger (over 170) number of vehicles established. However the majority of single country funds invest in the UK, with the next most popular European locations (Netherlands, Italy, France, Portugal) lagging well behind.
Funds also vary widely in terms of their ‘style’ – broadly speaking their risk profile. Core vehicles, which include all the German open-ended funds, have low risk/low return characteristics, target established property sectors and locations and use minimal gearing; these dominate with 70% of value, and around a half of individual vehicles. Core-plus funds, aiming for medium risk and medium returns (10-15% pa) with improving-sector properties and gearing around 50-60% make up about 16% by value, though in a relatively large number of smaller funds. Opportunity funds form the remaining 14%, aiming to achieve high returns (20%+) by investing in distressed assets and developments and gearing up to 100%.
Rising asset allocations to property are currently fuelling the growth of institutional interest in these vehicles – a trend that looks set to continue in the near future with the extension of the European Union. And as Pereira Gray confirms: “The unlisted market is here to stay – both in the UK and continental Europe; even if there are many issues to be resolved in terms of regulation and the level of service provided by vehicle managers.”