Taking stock of private funds
Investment in real estate has increased both in terms of asset volumes and by number of investors over the past two to three years. Continental Europe in particular has seen a more marked increase in investment, specifically through private real estate investment vehicles.
As investment volumes have grown so has the number of specialist vehicles available to investors, both in terms of investment criteria and fund structure. The majority of these vehicles have been designed to be tax efficient (if not transparent) for investors from different locations and with different tax classifications and are often more readily available on the continent. In comparison with the common vehicle structures available in the UK (managed funds and PUTs), they often target a higher level of investment return and as such are attracting high net worth investors as well as pension funds who are attracted mainly for diversification reasons. The majority of such vehicles available target niche investment arenas although some offer a diversified investment solution.
Whilst tax efficiency is understandably important from an investor standpoint the associated terms of investment should also be considered. Specifically, we would also recommend that the investment restrictions and criteria of such structures are closely examined. Whilst some investors may be looking for niche investment arenas, such opportunities are specialist and need experienced management. We are aware of some opportunities in the market-place offered by exceptionally small management teams with little or no financial backing and with limited market and vehicle experience. Investment in some markets such as Central Europe or the Baltic states may well potentially offer exceptional investment returns but liquidity and possible exit strategies remain a critical issue. Consequently, understanding the risk profiles of these investments and their suitability with respect to each investor is of the utmost importance.
In conjunction with the experience of the management team and the risk profile of the underlying investments, we also consider that investors should pay close attention to the process used to source stock. It is important to establish whether the manager is capable of generating a deal pipeline. Some managers are represented in their target markets whilst others have formed local partner arrangements. Investors need to be wary of the manager that does not adopt either one of these approaches, as there are only relatively few that are capable of sourcing deals without either structure in place. The initial valuation level of the properties transferred should also be closely investigated, particularly where a manager is seeking to transfer existing assets from another portfolio or where they have specifically purchased and warehoused them for the fund under consideration.
A main area of client concern and manager sensitivity is often fee structures. Whilst there is a move from some organisational bodies to promote standardised fee structures, this is far from the current market practice. Many vehicles have and are adopting private equity style fee structures which incorporate a complicated performance fee and are often opaque. In principle, we would consider that a clear performance related fee scale aligns the interest of the fund manager to the investor, but the level and calculation of such a fee is important. A share in the success of the fund payable by the fund manager, say over and above a hurdle rate is common, and understandable. However, the level of the hurdle rate and other elements of the structure must be set in line with the investment objective of the fund. If the target is set too high, the manager may be encouraged to take too much risk; too low and the investor may consider that the manager is being over-remunerated relative to the target returns for the fund.
The UK is behind other industrialised nations in its approach to vehicle structures, although it has undeniably been one of the most developed and transparent property markets within Europe. Whilst the likelihood of strong performance within a marketplace is obviously a key consideration for any fund manager and investor, as we have previously mentioned the suitability of each market place is also important. Investing in a single property or development is obviously a risky strategy in any market, but such an investment in Central Europe or the Baltic states would obviously increase the risk profile of the investment, as they remain relatively undeveloped.
Continental European markets are evolving at a rapid rate in terms of not only investment opportunities but also liquidity and transparency, and as such the volume of suitable investment opportunities available are increasing. Compared with, say, five years ago, investment vehicles are targeting a growing range of markets and as such you can diversify exposure within the market place to a level which until relatively recently it has been impossible to achieve.
Currency exposure is also an important consideration for investors, and the experience of managers to hedge within their funds if cross market investing is important. Currency markets are often inefficient and there is scope for a loss of value to the investor if this is handled inexpertly.
Investors are increasingly seeking advice about their investment strategy. It is becoming common to see investors even with relatively low amounts (say around €50m) allocated to real estate, invest across the continent for diversification purposes as well as perceived increased investment returns. As such, professional advisers need a thorough knowledge of the markets involved as well as the vehicle types available. As previously mentioned these are ever evolving and keeping abreast of market changes across Europe is important for professional advisors.
We are seeing a growing market developing for a multi-fund approach to investing in pooled vehicles. With a typical minimum investment size of €10m for the majority of real estate vehicles, investors would need a certain critical mass of €100m to build up a suitably diversified portfolio. Investors below that level would still be able to achieve some diversification but out of necessity their strategy would need to be more committed and targeted towards generalist funds investing in key European property markets on a multi-sector basis. As a consequence of investing in fewer vehicles their confidence levels in the vehicles invested would need to be very high so as to make the risk/return trade off acceptable.
Investors with much less money are looking at investing in more generalist funds that are diversified across sector and/or geographic region.
Investors with a considerable amount to invest are beginning to consider either Euro-zone or pan-European direct investment strategies. Although this gives the client more control about investment restrictions and removes vehicle specific risk the confidence in the manager chosen to execute the mandate must be high. The number of real estate managers with suitable coverage of Europe is increasing but the niche markets are still mainly covered by specialist providers.
Nick Duff is head of Hewitt Bacon & Woodrow's property team and Claire George is a consultant within the team, based in the UK