One outcome of the crisis is that the industry is re-examining the relationship between fees and operating costs. Simon Mallinson reports
The impact of the economic turmoil on investments has led the industry to call for a clarification of the relationship between the fees investors pay and the operating cost of the vehicles they are meant to support. In other words, investors have become much more cost conscious and expect their managers to be similarly prudent. During the boom, with its plentiful array of willing investors, the fund management industry could be accused of losing focus on the bottom line and running costs. The Financial Times recently reported that it felt the old adage ‘if you have to ask how much is costs, you can't afford it' neatly summed up the situation over the past five years.
The fee ratio that investors commonly look to when analysing running costs is referred to as the Total Expense Ratio (TER). The aim of the TER is to be a reliable indicator of the cost of management on a funds performance over the course of a year. TER is generally calculated by dividing the total operating cost by the fund's total assets and is expressed as a percentage. The TER total cost consists primarily of the fund manager's annual fees, but also includes all the various service fees paid for by the fund manager such as auditing, legal, financing and custodian fees.
In the wider fund management industry this fee often excludes, controversially, transaction costs (outside of real estate these fees are typically dealing costs, and entry and exit fees). Those who defend the exclusion of transaction costs from the TER equation cite the fact that the costs are the least predictable of costs and vary year on year. Therefore they are very difficult to build into the fee ratio and could mislead investors as to the expected costs in the following year. However, the growing number of large investors that support the inclusion of transaction costs in the TER say it is misleading on the total cost of investing in a fund not to include them, and that they help the investor to make an informed decision on the year-on-year costs.
Within the European real estate industry, the European Association for Investors in Non-listed Real Estate Vehicles (INREV) has published a ‘Management fees and terms' study for the past five years, and has outlined a standard for TER reporting since 2007.
The INREV TER is among a number of TER calculations that a fund can choose from when reporting costs. In INREV's latest study of December 2008, they helpfully included a statistic on the number of funds reporting using the INREV TER standard against those reporting using other standards (a mix of recognised industry standards, or home-grown manager definitions).
Of 243 funds included in the study, 35% (or 86 funds) report a TER of some form. This might seem like a low figure. However, this is up from only 33 funds (21%) the previous year - emphasising both the growing number of funds reporting the INREV's TER, and also the growing importance of reporting a TER figure. Of the 86 funds reporting a TER in the December 2008 report, 47 (55%) calculate the number using the INREV TER. This indicates that the initial adoption of the INREV standard is favourable.
In addition to reporting a backward-looking TER, a number of funds have taken to reporting a forward-looking TER, which should begin to prove popular with investors and their consultants as due-diligence work begins to put more emphasis on operating costs.
Consistency and comparability are clearly the most important elements for any investor to consider when looking at these types of cost ratios. With the current TER definitions there remain a number of ‘grey' areas that affect consistency and comparability. The most important of these is whether the denominator (or bottom line) of the TER equation is net asset value (NAV) or gross asset value (GAV). If the denominator used is NAV (which takes into account debt within the fund) then the TER will look higher than if the GAV is used.
Many investors are therefore now looking for fund managers to report TER on both a NAV and a GAV basis. This is very important when it comes to analysing the running costs of core versus value-add versus opportunistic investment, where NAV becomes more important because of the higher debt levels often associated with these higher-risk investments.
However, analysing and understanding TER within real estate funds must go beyond the simple percentage figure. As the INREV study demonstrates, the TER for funds targeting multiple countries is much higher than those for funds targeting single countries. Using NAV as the dominator the INREV study reveals that the average TER for funds targeting the UK is 1.08%, 0.99% for those targeting other single countries and 2.36% for those targeting multiple countries.
Investing cross-border is more management intensive, involving more legal structuring and complicated auditing processes (and therefore higher costs to be passed on via the management charges), subsequently resulting in a higher TER. Investors need to bear in mind these additional complications when judging single-country-focused or sector-focused funds against those with a cross-border, multi-sector approach.
Investors and their consultants across all asset classes currently have the upper hand in being able to dictate clearer, more consistent and comparable statistics from their fund managers. In the European real estate industry initiatives such as those developed by INREV are vital in creating a level playing field for fund managers to differentiate themselves based on investment and asset management skills rather than by fee levels and by the over-enthusiastic use of debt that we have seen in recent years.