Performance is determined by factors other than the portfolio, as shown by recent IPF research. Malcolm Frodsham explains

From 2001 to 2010, the UK commercial real estate market experienced a long bull market followed by a sharp correction. The period also saw a dramatic growth in pooled property funds.

Pooled fund units entitle the investor to a share in the returns from a portfolio of real estate assets. The investor has an exposure to the properties in the fund but also to the debt and cash within the vehicle.

Debt and cash alter the capital employed in the fund: leverage magnifies returns and losses while cash does the reverse. The interest received on cash and interest paid on debt will also alter the income distributed by the fund. Pooled funds incur costs to administer and fund sponsors will also deduct an investment management fee for their services.

Cash, debt and fees within pooled funds will create a divergence, therefore, in investor performance from that of the underlying market.

The Investment Property Forum (IPF) research report, ‘A Decade of Fund Returns’, sought to quantify the impact on fund performance of these additional dimensions.

To quantify the impacts of each of the drivers of pooled fund performance – particularly the effects of debt, cash, fund costs and fees – quarterly changes in net asset value (NAV) for each of the funds have been attributed to one of 12 categories.

Using these categories, the evolution of fund returns can be traced from underlying property portfolio performance through to the impacts of other investments, cash, debt, costs and fees, and eventually the final fund-level return.

While every effort has been made to identify all the drivers of changes to NAV, it has not been possible to quantify all of the data items. Therefore, there is a final category for the balancing item where the change in NAV could not be fully allocated between the categories.

Pooled funds entitle the investor to a share in the returns from a portfolio of real estate assets. Many fund managers had to manage substantial net inflows at a time of a highly competitive investment market, and subsequently rapid disinvestment during a period of falling capital values. These contrasting conditions tested managers’ skills to purchase properties when there was strong competition, and sell assets into a market bereft of buyers. Fund managers seem to have delivered; indirect funds in this study achieved a 7.1% annual return on their investment portfolios over the 10-year period.

The performance of the direct property held by specialist funds was higher than in the more diversified managed funds and other balanced funds. As a rough approximation, about half of this outperformance was due to the strong performance of retail warehouses and industrial assets, segments in which the specialist funds had a higher weighting.

Until the downswing began in late 2007, cash was consistently a drag on fund performance as interest earned was below the return of the real estate market. In the sharp downswing, cash offset some of the negative portfolio performance before diluting performance once more in the sharp recovery.

Cash balances were significantly higher in managed funds (as well as being open-ended, they do not distribute their income), averaging around 10% of gross asset value (GAV) until September 2004, 6% between then and December 2008, and 10% again thereafter. Cash balances on other balanced funds averaged around 4% of GAV until 2010 and then peaked at 9% in the second quarter of 2010.

Most specialist funds are closed-ended, where cash balances are not impacted by regular investment flows and portfolio income is treated separately in the balance sheet to the NAV calculation.

Cash balances on specialist funds rose significantly after June 2008, averaging 1.9% before and 4.2% afterwards. The rise in cash balances was predominantly due to a diversion of income in an effort to resolve breaches of loan-to-value (LTV) covenants.

Over the cycle, cash reduced investment returns on average by -0.19% per annum. Managed funds, with their higher cash balances, experienced the greatest dilution of fund returns due to cash.

Specialist funds with their higher cash balances in the downswing and lower cash levels in other periods experienced the lowest dilution from cash.

Debt reduces the capital employed in the fund, so leverage amplifies fund capital returns if capital growth is positive. If interest payments on the debt are below the rent received on the real estate portfolio, total returns are further enhanced.

Leverage was significantly higher on specialist funds over the 10-year period, averaging around 33%. Debt balances on other balanced funds averaged around 7%. The unweighted average of other balanced funds that utilised debt was 16%.

In the upswing, specialist fund leverage fell to below 30% from late 2006 through 2007. Balanced funds tended to exhibit lower gearing prior to the upswing, only rising above an average of 9% in 2008. In the downswing, debt levels rose, reaching average levels of over 40% in 2009 on specialist funds and over 10% on balanced funds.

This is evidence of the ‘Black’ leverage impact. The degree of leverage naturally falls as portfolio values rise in an upswing and the leverage rises as portfolio values fall in a downswing, so gearing tends in peak in the downswing rather than in the upswing. The only way to avoid this impact is to reduce the stock of debt more quickly than the market falls – clearly, this was not easy for funds to achieve in practice.

The overall impact of the ‘sound and fury’ of leverage through the cycle was a tiny increase in overall fund returns. Specialist funds benefitted to the tune of 90bps while other balanced funds lost 19bps.

Fund outgoings and fees
Fund outgoings and fees are a direct reduction from the return delivered to investors. Fund outgoings lowered returns by 0.26% per annum and fund and performance fees reduced returns by a further 0.99%.

Fund outgoings were highest on the specialist funds: a result that is in keeping with these funds holding stock requiring more active management than the more balanced fund types.

Performance fees can also be difficult to estimate, with complex calculations (how many investors could work them out without the assistance of their finance director?) and accrual provisions so that, in some instances, total fees will not be known until the fund is wound up.

Investors are charged a premium to invest in a fund over NAV to compensate existing investors in the fund for the acquisition costs already incurred on the existing portfolio – the bid-offer spread. The premia or discounts from trading in units on the fund increased returns by 0.37% per annum.

While every effort has been made to allocate all changes in NAV to a category, a reconciliation error of -0.20% per annum remains.

The contribution of other investments plus the impact of cash, debt, costs and fees reduced the return from pooled fund vehicles from a direct property return of 7.2% per annum to a fund level return of 5.8% per annum.

This study has sought to document the impact of the dramatic market cycle on pooled funds and how the debt, cash and fees affected fund returns. These impacts are being digested by the unit holders in these funds, as they determine their future investment intentions, and also by the sponsors of these plans when deciding how to structure such funds in the future to avoid some of the pitfalls experienced over the period.

As in many financial innovations, the features of the first generation of funds will be modified to leave a solid investment product that is an excellent route for many investors to access the real estate market.

Sponsors have worked on codes, such as the AREF Code of Practice, to improve transparency on accounting and fees, and many funds now go beyond the minimum requirements.

Investors understand there are costs in running real estate funds. Fees should be fair and appropriate to the work involved and the performance delivery achieved, so as to align the interests of investor and fund manager. Suitable benchmarks are available to compare investment performance, and performance fees can be constructed that share returns between fund manager and investors fairly.

With more transparency in these costs, it is likely that these funds will attract investor cash in future.

One hopes that fund managers and investors can plan their strategies for whatever the next cycle might bring, to manage their liquidity and leverage requirements to deliver investors an attractive return for the risks they are taking.

Malcolm Frodsham is an independent consultant