The direct or indirect decision
European investors are expanding their view of appropriate vehicles and geographical locations for investment in property. The advent of the EU and an increasingly global economy are changing the way investors think about investment strategy and diversification generally. More specific to property, there may be a mismatch between domestic investable capital for European investors and the size of their domestic investable property market, leading to cross-border investing. In addition, the evolution of indirect property investment vehicles and the adviser communities supporting them is bringing increased attention to various ways, other than direct investing, to participate in property.
In this article, we will discuss ways in which European investors may choose to approach the US property market. Where appropriate, we will compare traditional European property investment practices and those available in the US.
CB Richard Ellis estimates the US investable universe of institutional-quality property at $1.2trn. The charts break this down by type of owner and property type. It should be noted that, relative to Europe, there is a significant opportunity to invest in apartments (for-lease residential) and industrial assets. It should also be noted that the NCREIF (private pensions reporting to the National Council of Real Estate Investment Fiduciaries) investment universe is smaller than the publicly traded Real Estate Investment Trust (REIT) universe. Many pension investors include public securities in their property portfolios; although it is difficult to generalise about various investors’ strategies, many pension plans allocate approximately 20% of the property allocation to the public market and 80% to the private market.
Private market property investment: core strategies
Core property strategies are pursued by investors that are looking for property to provide diversification to a financial asset portfolio, with low volatility and a strong current income return. Core strategies may be pursued directly, through property purchase, or indirectly, through commingled funds.
Direct investment is an appropriate option for large investors planning to allocate $500 million or more to a US property portfolio. The advantages of direct investing include control (although some service providers only take accounts where they retain full discretion), the ability to customise a portfolio to investors’ specific needs, and, potentially, lower fees than a commingled approach. Disadvantages of direct investment include potentially limited diversification leading to asset-specific risk (depending on the size of the allocation), prolonged implementation time to acquire assets one-by-one, and limited liquidity. It may also be difficult to design appropriate performance benchmarks.
There is a robust group of pension fund advisors offering separate account property services in the US. Many of these firms are well known in Europe as well. However, many firms are moving in the direction of offering fund products that are deemed by advisors to be a more efficient way to manage all but the largest accounts. An increasingly popular option for separate accounts is investing with public or private operators through joint venture structures. Non-US investors will need to evaluate tax mitigation strategies.
The second option for core investing is through commingled (multi-investor) fund vehicles. Over the past decade, the US market has evolved to provide robust open-ended funds specialising in core, private property investment. As discussed below, closed-ended funds increasingly target only higher-risk strategies.
Currently, there are 17 open-ended funds, with a total capital value of $29 billion. They range in size from $250 million to $5.5 billion with 11 having net asset values of over $1 billion. A number of the funds use structures, including insurance company separate accounts and bank collective trust funds, that European or other non-US investors are not qualified to invest in. However, open-ended managers are increasingly interested in attracting non-US capital and several are altering their structures to create appropriate vehicles for foreign investors. In addition, any newly forming funds generally have appropriate structures to accommodate non-US investors. Russell estimates that by the end of the year there will be seven open ended funds eligible to accept non-US capital; this includes four existing funds and three new funds currently being set up. The private REIT structure is being used with greater frequency; funds which are structured as private REITs or which invest through a private REIT may provide tax benefits for certain non-US investors. Many of the funds are broadly diversified by property type and region within the US; to a lesser extent, some are concentrated by property type.
Open-ended funds provide for quarterly entry and exit. Typically, funds accept new capital flows at the end of each quarter (although several are currently temporarily closed due to unusually robust capital flows) and provide for a fund-level redemption provision quarterly. Redemption, as well as entry, is provided at a fair market value per unit established through a third-party appraisal mechanism. This differs from the liquidity mechanism for certain European private vehicles (including UK PUTs) where liquidity is provided in a secondary market and, generally, on a discounted basis. Redemption by open ended funds is, however, limited to cash available due to new contributions, property sales and financings; each fund has specific provisions detailing the limits to their liquidity. Inflows and outflows have been well matched and growing in recent years.
The advantages of open-ended funds include the fact that they are immediately investable into property assets, provide excellent diversification, can be benchmarked against an index and are liquid at par value (subject to certain conditions, which are designed primarily to avoid the forced sale of properties, particularly during periods of illiquid property markets). Disadvantages include lack of control, other than the ability to exit, and the limited options for non-US investors for structural reasons.
Providers of open-ended funds in the US include many of the major pension fund advisors. A number of firms have sponsored these products for many years and others are currently creating such vehicles, recognising their popularity. Advisors view them as flagship products. Fees for open-ended funds may be slightly higher than those for direct separate account services.
Private market property investment: core strategies
Non-core investing refers to the practice of investing in higher-risk property strategies (including, for example, poorly leased assets, rehabilitation, development, portfolio sales from distressed sellers, and non-traditional property types) using higher amounts of leverage to achieve higher returns. During the past decade, several fund sponsors emerged offering these “opportunistic strategies”, those targeting returns before fees and incentives in excess of 20%, largely through appreciation and with limited current cash flow. This represents the private equity sector of the property market, typically pursued through closed-ended funds with performance-based and potentially lucrative manager compensation.
These funds emerged in the US following the recession and distressed debt crisis of the early 1990s, but many have subsequently migrated to non-US markets and have specialised programmes in Europe and Asia, which co-invest with their US programmes or can be accessed independently. Non-US investors will need to carefully evaluate the structure of any such funds. Some attempt to structure their funds or underlying investments to protect investors from onerous taxes associated with cross-border investing.
US-based non-core funds typically have a minimum fund size of $200 million to $250 million and may be as large as $1.75 billion in equity; total purchase power equates to about $1 billion to $9 billion, reflecting the funds’ ability to use leverage/gearing up to 80%. These funds have broad investment mandates across a range of property types (traditional property types but also less traditional types – examples include golf courses and senior housing – and property related assets), investment structures and locations. This is in contrast to the European market, where closed-ended funds often focus on a single property type in a narrow geographic region and may be fairly small, with asset-specific risk.
The purported advantage of these funds is the ability of sophisticated management to nimbly access out-of-favour assets, while properly aligned with investors through significant co-investment and incentive compensation. Illiquidity is a big disadvantage. The non-core fund universe has had mixed success – some firms have delivered on their targeted mandate, others have fallen well short. The industry is undergoing a shake-out in which the strong will survive and the weak will not. In addition, deal terms, including fund economics, are increasingly moving in favour of investors.
Investors should also note that there is a growing sector of value-added funds that target returns and risk levels intermediate between core and opportunistic. In addition to closed-ended value funds, there are newly forming vehicles that couple a value strategy with an open ended structure. Value-added funds focus on traditional property types in the US only and use debt levels in the 50% to 65% range. They are of modest size ($200 million to $750 million) and typically promise some amount of current cash flow to investors. These funds may be well positioned in the near term because their objectives keep them out of the competitive set of the "trophy" asset buyers yet they avoid higher risk strategies.
Public market property investment
Public market property securities are a vibrant and growing sector in the US. Beginning in the early 1990s, the industry grew dramatically when overleveraged private operating companies were welcomed into the public market format by investors looking for a way to invest in property that included high-quality assets, strong and active management, corporate governance, diversification and liquidity.
The US REIT market currently comprises 144 companies, with market capitalisation of $205bn (up from $6bn in 1990). Most REITs focus on one property type with a US regional or national presence. Asset types such as retail regional malls, where national operating synergies can be exploited, are significantly represented. There are 10 REITs with equity market capitalisation in excess of $5bn; six are S&P 500 constituents.
An important feature of public market property securities in the US is the real estate investment trust (REIT). This structure provides that the underlying companies do not pay corporate income tax, provided that they meet certain requirements, including distribution as dividends of 90% of their taxable income. In Europe, a similar structure is in place in the Netherlands and Belgium, and has recently been approved in France and appears to be under discussion for the UK. The tax-transparent structure allows US REITs to trade, in certain market environments, at or above underlying asset value, whereas property companies without such a structure (for example in some European countries) may be more likely to trade at a discount.
REITs had an excellent year in 2003 with a total return of 37.1%, driven by strong investor interest in securities with secure cash flow. Over the long term, REITs can be expected to provide a return equal to or slightly greater than private property, due to similar underlying asset holdings complemented by strong operating management and moderate levels of leverage.
The public REIT market may be accessed through separate accounts, mutual funds and funds-of-funds. There are approximately 35 managers offering specialised services in this sector.
Advantages of investing in REITs include: property-like returns coupled with liquidity, strong dividend cash flow and the ability to access some of the strongest management teams in the US property sector. The main disadvantage is the increased volatility due to public market trading which decreases the diversification benefit of property in a mixed asset portfolio.
Depending on a specific investor’s goals, there is an array of core and non-core and public and private strategies that can be implemented. Investors who approach the market with careful research and relevant counsel will be appropriately rewarded.
Carol Broad is a director, real estate research, and Sally J Haskins is a senior research analyst with Russell Investment Group in Tacoma, Washington