INREV's debt study shows most concern about 2006 and 2007 fund vintages with respondents aiming for less debt reliance. Dasha Kruchkoff reports

Prior to 2007, when commercial real estate prices were continually rising, few investors or fund managers questioned the levels of leverage being employed in non-listed funds. Two years on as the industry looks back on major falls in capital values, debt has been firmly put in the spotlight.

With this in mind, INREV surveyed its investors and fund of funds managers to find out their main concerns about the use of debt in non listed real estate funds. INREV also interviewed bankers about their views on how fund managers were dealing with debt issues.

The report focuses on the concerns and availability of debt in the non listed real estate funds market during 2008 and the first three months of 2009. The results show that while investors are in agreement over the vintages of problem funds, there are more surprises by funds style. Bankers are still positive about fund managers. However there is room for funds to improve communication on debt issues.

The debt survey 2009 attracted 42 responses from INREV members: 25 from investors and 17 from fund of funds managers. The majority of these respondents are located in Germany, Netherlands or the Nordics (64%) while 17% came from other Western Europe countries and 9% from the UK. Six interviews were conducted with property bankers across Europe.

The results show that debt issues were most obvious in funds with vintages in 2006 and 2007 (figure 1). At 94%, the largest proportion of investors saw 2006 as the worst vintage while fund of funds managers, at 93%, chose 2007. The results come as no surprise when it is considered that it was these two years when capital flows were at their peak in the European non listed real estate funds industry. According to the INREV Capital Raising Survey about €14.5bn was invested in the sector during these two years.

The survey also asked respondents which style they considered to have the most and the least problems. Mainly respondents rated opportunity as having the most and core having the least. However it is interesting that one third of investors see the most difficulties in value added funds rather than opportunity funds (figure 2). This could be explained by a high number of investors having invested in value added funds, which is confirmed by the last three annual INREV Investment Intentions surveys where value added is the preferred style.

One consequence of the debt issues is that investors and fund of funds managers have been asked to commit more equity to the funds they are invested with. When asked to report on this activity in the survey, 54% of investors and 63% of fund of funds managers received such requests since the second half of 2008. At 50%, a higher proportion of fund of funds managers have been asked but have not committed new equity compared to a third of investors.

Looking to other consequences, about 28% of investors and 24% of fund of funds managers reported that a fund that they are invested with had defaulted on a loan. However, financing terms were predominantly re-arranged with an existing lender according to 76% of investors and 82% of fund of funds managers. A further 56% of investors and 47% of fund of funds managers are invested in funds which have refinanced with a new lender (figure 3).

Problems with debt have also seen bankers take action with the problem loans held by funds. The interviews conducted with bankers show that this was much more likely if loans were not maintaining interest coverage ratios as opposed to breaching loan to value ratios.

When reflecting on how fund managers have dealt with debt issues, the bankers interviewed have been satisfied to date with the level of professionalism. However, bankers would like to see fund managers show more initiative to highlight or suggest solutions at an earlier stage. They also mentioned that it would be crucial in the future for fund managers to improve communication with banks in the future. They said they expected similar levels of communication and transparency that fund managers afforded investors.

In light of debt issues bankers said there will be more of a focus on relationship banking. They expect loans will be more deal by deal focused taking into account the personality of the fund manager, property opportunities and returns. Some commented new business with fund managers would be prioritised to those fund managers who can prove they are good property managers, not just financial engineers.

The survey also asked investors about the adequacy of communication from fund managers on debt problems. Like bankers, the results show that there is more room for improvement from fund managers. Communication on debt problems was found to be average for 60% of investors and 71% of fund of funds managers. Furthermore about 16% of investors found communication regarding debt issues from fund managers to be poor.

Overall, less reliance on debt as part of the non listed property funds strategy is expected to be the way forward (figure 4). Investors, fund of funds managers and fund managers were asked to give a two year outlook as to how they view future reliance on debt as part of the funds strategy. About 88% of investors and 82% of fund of funds managers expect less reliance on debt.

The surveys and interviews clearly show the prevailing concerns relating to debt and its use within the non listed real estate funds industry. Fund managers have dealt professionally with debt, but their lack of communication has been brought into the limelight. The consequence of the debt difficulties is that investors and bankers will likely have a more conservative outlook on debt levels and strategies in the future and are looking for fund managers to keep lines of communication open.

Dasha Kruchkoff is research manager at INREV