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With the European market for real estate investment expanding, and investors looking for different ways to access it, the US market offers insights into the types of vehicles that could maximise opportunities. By size, the US accounts for about 40% of global real estate investment. Europe (31%) and Asia (26%) are the second and third largest markets.
US institutional investors tend to use direct private equity funds, both open and close ended. In recent years, however, public debt and real estate securities have become important alternatives, with the latter particularly popular wih retail investors. These are viewed as indirect investment vehicles. In the US, REITs have taken centre-stage in recent years because of their strong returns and tax-efficiencent structures. Europe has been slower than the US to adopt alternative real estate vehicles, but this is changing fast.

Real estate investment in the US
q Private funds US real estate institutional investment is dominated by private equity funds. These are usually structured as open- or close-ended funds that offer investors flexible options. Depending on their targeted returns and risk, these funds are classified as core, value-added or opportunistic. In addition, investment managers run separate investment accounts for dedicated clients.
q Open-ended funds are privately traded and usually require a minimum investment of $2m–3m. Investors have the opportunity to redeem their capital every quarter and an appraisal-based method is used to value the fund. Such funds are distanced from stock market volatility and tend to be highly diversified.
q Close-ended funds, on the other hand, typically require a slightly higher investment minimum of $5m–10m with investors locked in for seven to 10 years. Investors in such funds typically benefit from a focused strategy. The disadvantage, however, is a lack of liquidity, with investors typically having no redemption options other than waiting for the fund’s termination.
q Separate accounts are yet another way institutional investors can access the US market. Because such funds require dedicated teams, a minimum of $100m is usually required to start the fund and periodic infusions of capital are common. Advantages include access to a dedicated team and substantial control over the fund. The major drawback is size – research suggests that true diversification does not occur until the fund reaches about $500m.

Public debt
Institutional investors have also become active through commercial mortgage backed securities (CMBSs). Typically, CMBSs are bonds backed by a pool of mortgages on commercial real estate. They are widely traded but susceptible to stock market volatility. Cash flows from the pool of mortgages are typically broken into tranches that are rated on the underlying quality of mortgages held. The segregation into different tranches gives investors the opportunity to select an appropriate risk/return strategy. According to Commercial Mortgage Alert, a record $77bn of new CMBSs were issued in 2003.
Institutional investors may confine exposure to investment-grade CMBS offerings or focus on more opportunistic higher-yielding issues that are more often viewed like real estate equity. The major advantage of CMBS vehicles is liquidity, along with the ability to access real estate indirectly. Mortgage delinquencies are the principal risk, particularly for the lowest-rated tranches in the first-loss position. Analysis of the underlying real estate is therefore critical.

Public equity
REITs are increasingly popular among both institutional and retail investors. REITs are aimed primarily at small investors who would normally not be able to participate in property investment because of the large amount of capital required. Although there are four types of REITs (mortgage, hybrid, specialised and equity), the most common and important are equity REITs. REITs own approximately 12% of all institutional quality real estate in the US
These REITs are companies that own commercial real estate and are structured so that they must pass through a minimum of 90% of their taxable income as dividends to investors. Initially structured as ‘pass-through’ passive conduits, REITs were given a significant boost by the tax Reform Act of 1986 which allowed them to manage their own properties directly. In 1993, REIT investment barriers for pension funds were removed. These changes led to a spate of private REITs going public.
REITs became even more attractive with the REIT Modernisation Act of 1999. This allowed them a greater role in managing their properties. Under the old structure, REITs had to restrict their activity to generating income from property. The new legislation, which came into effect in 2001, expanded the types of activity from which REITs could generate income, enabling them to compete with non-REIT rivals, operate more efficiently, and have more control over the services provided to tenants.
Under the Act, REITs can own a taxable REIT subsidiary (TRS) that can provide services to the REIT tenants without disqualifying the REIT’s tax status. For example, through TRSs, REITs can offer renter’s insurance and cutting-edge technology services. A REIT and its shareholders then gain the financial benefits of providing those services through dividends paid by the TRS. Although, the TRS is fully subject to corporate income tax on its taxable income, the change was an important step that allowed REITs greater opportunity to improve shareholder returns.
The 2003 REIT Improvement Act made minor corrections to the tax rules. Two were particularly important. One allowed companies to hold commercially ordinary debt that under the 1999 Act would have caused the loss of REIT status. The second conformed the tax treatment of foreign institutional investors in REITs to that of similar investments in other publicly traded companies as well as conforming the capital gains treatment. Such changes continue to increase REITs’ appeal; in 2003 real estate companies raised $8.2bn in common equity.

Europe: the growth of REIT structures
As in the US, in Europe private equity funds have been the dominant estate investment vehicle. Over the past decade, however, some European countries have taken an active lead in developing tax-efficient REIT-like structures. The Netherlands, Belgium, France, Luxembourg, Italy and Germany have been early adopters. The UK and Finland are expected to follow soon.
Interest is being largely driven by the tax efficient nature of the vehicle (not taxed at the corporate level) as well as the desire to place funds with property specific specialists. Some European real estate investors and companies such as the European Public Real Estate Association (EPRA) and the European Association for Investors in Non-Listed Real Estate Vehicles (INREV) are taking an active role in creating an optimal pan-European tax transparent vehicle. The explicit goal is to develop a blueprint for a “EuroREIT”.
Will McIntosh is global head of research and strategy and Indraneel Karlekar is a senior research associate with ING Real Estate

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