The recent return of capital flows into publicly listed real estate companies could signal that the tide is also turning for the unlisted sector. But which is better placed to capitalise on opportunites? Christine Senior reports

Publicly listed real estate companies have been surprised by the rapidity of the turnaround in their ability to raise capital. Equity has gushed into REITs over the past few months, confounding expectations. Some €6.47bn flowed into EPRA index constituents in the UK in the first 10 months of the year, and €1.48bn into continental Europe.

Although not necessarily flush with cash, as much of the inflow has been used to pay down debt, REITs do seem well placed to re-enter the market as and when opportunities arise. On the other hand, unlisted real estate funds, often much more highly geared than their listed counterparts, have found themselves weighed down by leverage, up against breaches of covenants, and often in need of further injections of cash just to survive.

It has not been plain sailing for REITs, though. Steve Coyle, chief investment officer for Cohen & Steers' global private real estate multi-manager strategy, says that for some the question was whether REITs would survive, which depended on how big the correction was going to be.

"If they had equity left they had the ability to re-capitalise, if the markets could believe it. They had to bring debt levels down to more manageable levels. REITs started by cutting dividends. They went on to do rights issues, then corporate level debt, which at first was very expensive. Through corporate level debt and equity, the REITs have de-geared. And some cash was left over to do new acquisitions, but most was used to de-lever. Round two for the REITs will be when they start acquiring properties at attractive prices."

When the credit crunch kicked in last year, particularly after the demise of Lehman Brothers, it was evident that debt was no longer going to be an accessible means of finance for the listed sector. With bleak prospects for refinancing loans due to mature from 2011 to 2013, equity seemed to be the only way to source capital, but it was expensive.

"The companies were forced to re-capitalise themselves with equity at very expensive pricing, but the listed companies have survived with a few exceptions," says Robert Promisel, director of real estate securities at Invista Real Estate Investment Management. "They were able to raise equity capital in very challenging market conditions. They have completely destroyed an immense amount of shareholder value by pricing equity at the level they did but companies were able to stay in business."

Shareholders would be justified in feeling aggrieved at being placed in the position of having to re-capitalise listed companies, and the consequences for them.

"The listed structures had become very highly geared and tapped their shareholder equity to convert debt to equity to reduce their debt and re-balance their books," says Andy Rofe, managing director of Invesco Real Estate. "Existing shareholders haven't had a lot of choice about that. It's effectively been good money after bad. In the process it has wiped out their returns over the past five or 10 years, depending on which structures they have been in."

Promisel feels that many REITs have skilled management teams and good portfolios where value has been created for shareholders, but he is critical of shareholders continuing to support poor management in other cases: "Many companies have rather mediocre value propositions for investors where the management doesn't have a distinct track record of creating value for investors at the property level. Frankly, shareholders should have forced some of these companies to find better management teams, perhaps through mergers."

Rofe expects to see a shift in capital raising from existing REITs to new players coming to the market, which will not be carrying the baggage of the past few months.

"We have seen a few new listings on the IPO market, mainly through people who have long-standing reputations in the industry and have been able to attract new capital," says Rofe. "Going forward, there is more likely to be equity raised with new listed vehicles rather than existing REITs."

But it is not only equity that public companies have good access to. They have an advantage in the debt markets too. "Listed real estate companies also have good access to debt capital at more favourable terms," says John Lutzius, managing director international at Green Street Advisors. "In the current environment where debt capital is scarce, public traded companies that have generally reasonable debt levels, professional management, good disclosure and good corporate governance in their favour are getting better access to finance than some of the more leveraged private players."

Robert Oosterkamp, portfolio manager for European listed investment strategies at AEW Europe, adds: "Companies can raise capital in the equity market which, at current share prices, is not dilutive to their NAV. But they can also still raise capital via debt. The reason is that most of these companies have been around for 20 or more years and have well-established relationships with their banks, and their debt needs are not as high as some of the private equity strategies."

Promisel is calling for greater levels of transparency in European REITs, to bring them up to the level of disclosure that is offered by their US counterparts.

"Companies don't provide the level of detail that would help investors make informed decisions. They don't usually provide adequate detail on occupancy, and on cash flows such as net rents and expenses. Oftentimes for listed companies in Europe the appraised value is the level of disclosure you get, which is insufficient. I would encourage listed companies in Europe to look at supplemental disclosure packages from any number of US REITs to understand the level of disclosure in that market."

Levels of disclosure varies considerably among companies in different parts of Europe. Generally the UK, the Netherlands and Switzerland have been more transparent. Fraser Hughes, research director at EPRA, says that even within different jurisdictions the level of transparency varies.

"You have to look at this on a company by company level," he says. "In the annual report award we run with Deloitte there is a large variance in the quality of company reporting. Even in the UK the range between top and bottom is massive. The major ones receive excellent marks."

The private markets are not as well placed as the public ones to attract cash to sort out their balance sheets. They also have a bigger mountain to climb to reach a stage where they will be able to make acquisitions. In many cases they have been weighed down by heavy burdens of gearing, particularly those funds concentrated on the value-add and opportunistic sector of the market where leverage could be as high as 65-85%, and pushing higher as values have shrunk. Often the market carnage has completely wiped out any equity in the funds.

Any capital raising activity in private vehicles has generally been targeted at solving debt problems. This activity is under way but it has not made the impact that capital raising in REITs has, says Rob Wilkinson, head of European fund management and separate accounts at AEW Europe. "On the unlisted side there has been a huge amount of re-capitalisation going on. But what has been going on has not been as visible as in the quoted sector. The activity has centred mainly on the restructuring of debt in unlisted fund vehicles."

Many funds have had debt problems due to plunging valuations and have been negotiating with their banks. In less severe cases the solution has been agreed through relaxation of LTV covenants, changes of margin charges by lenders, and injections of new equity, but cases of more extreme distress have resulted in complete restructurings of both equity and debt.

But if the private funds face hurdles compared with their listed counterparts in accessing capital, they do have advantages because of the smaller number of investors involved, which can make it easier to find a solution.

"The raising of capital, in my experience, takes longer in unlisted funds than the listed," says Wilkinson. "But I would say one of the big advantages in unlisted funds is that where you have a much smaller number of investors in those vehicles, they can agree together to find a solution that ultimately is not as dilutive to existing investors [as it has been for listed funds]. Dilution doesn't occur if it's done on a pro rata basis."

Despite the fact that the capital is for the most part concentrated in the listed market, it is not a straightforward split between buyers in the listed market and sellers in the unlisted. It's more a polarisation between those with the capital to invest and those without. There are active buyers in both camps.

"There will be active buyers on the listed and unlisted side," says Wilkinson. "It may be different players to those most active three years ago on the unlisted side but there is a lot of capital looking to access the UK market. People who have never invested in the UK or European real estate in the past suddenly are coming to the market today."

It is the longer-established unlisted funds that have been best able to weather the storm, according to Wilkinson. "As the unlisted fund market went through exponential growth over the last 10 years many more jumped on the bandwagon," he says. "Those which haven't been around that long probably tried to grow fastest and are the ones probably feeling the pain."

One reason the listed market has been ahead in its re-capitalising activity is simply to do with its structure and the timing of market changes. Listed funds were hit earlier in the cycle and forced to deal with the issues arising. With transparent daily prices for REITs on stock markets, values were immediately visible, unlike with the unlisted funds where values are based on appraisals.

"On the continent, fund values were not adjusted until the third quarter of last year when the listed market had already experienced the biggest part of the downturn," says Lisette van Doorn, former chief executive of INREV. "They had to act much more quickly than non-listed funds."

But van Doorn takes activity in the listed market as a positive for the unlisted funds: "I think the recovery we see for listed is a leading indicator for non-listed funds. What we have seen for listed fund is happening now, or is about to happen, for non-listed funds."
Coyle also sees some positive factors for non-listed funds. In some cases they have a time advantage over REITs, he says.

"Some REITs will acquire vacant buildings that will take years to lease out, but most won't, whereas there are some private funds out there which will be able to take advantage of this blood on the streets," he says. "They don't have to show earnings for a number of years. They will take years to lease properties up, to deploy the capital to make improvements. There are different opportunities for them."

REITs might buy assets from the unlisted funds, which has always happened in the past. But the traffic can go in the other direction.

"Last year REITs have been selling and have sold to the private sector, simply because in a few cases the private funds had the cash." says Rofe. "There are still commitments to the unlisted sector, which represented available cash for the funds without the need for debt, so they were active in the market. The other way round the REITs are actually looking for active management or development stock that they would look to develop over the next the next four or five years."

Until the market frees up, there is little immediate prospect of more activity. A dearth of distressed properties means there is little available for buyers seeking investment opportunities. And immediate prospects for increased liquidity look bleak.

"I don't know what is going to break it," says Hughes. "It's still not a liquid market. Maybe companies that can't refinance will be forced to sell. But my gut feeling is that I don't expect a glut of distressed properties to come onto the market. By hook or by crook, people are holding on to what they've got. But I think the listed market is best positioned of all property vehicles to take advantage of opportunities going forward."

Promisel is optimistic about prospects for the listed sector in the short term: "I think the share of real estate owned and controlled by the listed sector is likely to increase over the next three to four years," he says. "That wasn't clear 12 months ago."