IPE Real Estate asked real estate fund managers and fund of funds managers for their view of the most important lessons to come out of the credit crisis and the main challenges that lie ahead. Here are their responses

Rickard Backlund - Aberdeen Property Investors
The credit crisis has challenged many assumptions about the construction of investment portfolios, for property and other assets. The property market slump followed an unsustainable boom, when some investors, scrambling to access the market, lost sight of market fundamentals and what constitutes ‘fair value'. The result has been a sharp reminder that the market is cyclical, and lessons should be learned.

Pricing tends to overshoot fundamentals: In the boom times, the laws of supply and demand mean that competition for stock causes prices to increase and investors to become less discriminating. The effect of the latter causes risk premia to reduce for less secure or more volatile assets (for example, secondary stock and emerging markets). When the risks reassert themselves in the downturn, these assets are then punished disproportionately as risk premia rise. An example is the collapse in asset values in the developing markets of Central and Eastern Europe. The opportunity now is that markets overshoot on the downside too, so this is creating opportunities as markets over-discount risks.

Debt can be an enemy as well as a friend: In a rising market, leverage boosts performance, and allows larger portfolios to be assembled, but at the cost of increased volatility. High take-up of cheap debt sowed the seeds of its own destruction as money flowed into the sector, forcing yields down to levels where income no longer always covered interest costs. As boom turned to slump, leverage became a burden rather than a benefit. There has been a marked shift away from highly leveraged funds and debt instruments, and a general reduction in risk appetite.

Good asset management is key: Falling capital values have refocused attention on income return and tenant retention - ‘old fashioned' asset management skills that are once again critical drivers of performance.

In future, managers should focus more on market fundamentals, and place less reliance on financial engineering to generate returns, with new products and investment strategies aligned accordingly. The challenge will be to harness skilled, local deal sourcing and asset management teams to identify and exploit opportunities, supported by strong governance and treasury management processes.

Robert Steers - Cohen & Steers
The boom/bust cycle of the past two years has illuminated two divergent approaches to real estate investing: fiduciary and trading.

Whether by charter (as with listed REITs) or by design, fiduciary investors generally maintained discipline in the way they approached leverage, valuations relative to the cost of capital and diversification. In other words, they managed their real estate portfolios with valuations and financial risk as governors on their capital allocation strategies. These entities will be the big winners over the next cycle.

By contrast, trading-oriented investors generally ignored these important strategic considerations, and rationalised large, over-leveraged, awkwardly structured deals at historically high valuations. Their goal was to get the deal done. However, simply buying is not necessarily prudent investing. These investors will not survive the current cycle intact.

On the whole, real estate traders delivered neither alpha nor diversification over the past cycle. Acquiring properties using excessive amounts of low-cost leverage without regard for valuations created the illusion of high relative returns (alpha). In fact they created levered beta with limited diversification.

Liquidity appears to be the greatest challenge facing the real estate industry. Well over one trillion dollars of debt will mature in the next three years; substantial amounts of equity will be needed to replace lenders and reposition, re-tenant and redevelop properties. Given the magnitude of the credit crisis and the continued reluctance of banks to lend, the main source of capital will likely be the public equity and debt markets, followed by the few large and liquid pools of institutional capital that exist today.

Attracting capital back to private real estate will require better alignment with investors and true fiduciary standards. In addition, investors will be better (more highly) compensated for the significant risks inherent in these more aggressive strategies and structures.

Increasingly, investors looking for attractive risk-adjusted alpha with liquidity and transparency will choose the public markets. Those who elect to remain private would be well advised to structure, lever and manage their transactions with the same discipline as REITs. If they properly align the strategies with the structures, and embrace the most basic disciplines regarding real estate valuations, then the real estate industry will emerge from the current downturn sooner, and stronger, than expected.

James Quille  - MGPA
As economies across the world are beginning to grow again, there are two key lessons worth remembering.

First, people's willingness to rely on the free market is a pendulum-like phenomenon. It starts with blind trust for the market to come up with solutions. Then the shortcomings of those solutions are uncovered and there is a call for regulation. Then the inadequacy of government involvement becomes evident and people want the free market back, and so forth. Because neither extreme is perfect, the oscillation between them goes on. Governments aren't fit to run economies or companies. But it's equally true that in a free market, things will inevitably go past the optimal to the extreme.

Secondly, those who ignore historical evidence are bound to repeat it, for better and worse. Property is the ultimate cyclical investment, and overconfidence at the peak of the last cycle sowed the seeds of the severe downturn that followed. A herd mentality is fatal in investment. A certain level of conservatism is necessary as it is only when investors are sufficiently risk-averse that markets will offer adequate risk premia. Deleveraging and unemployment effects will take time to manifest themselves and with a large overhang of distressed assets owned by undercapitalised banks, we can expect a saw-tooth profile to real estate values as banks look to sell on recovery. To take advantage of this environment, fundamental real estate skills are necessary to partner with banks and add value to the underlying properties: "real estate is not a financial asset".

The main challenge ahead comes from finding value and managing risks as we come out of the trough of the downturn. The macroeconomic picture is highly uncertain with, among others, a fundamental debate on inflation and deflation, a key variable for real estate. This requires patience, a focus on finding value, and managing portfolio risks. These conditions should work to our advantage, as we have historically focused on opportunities to create capital appreciation opportunities through repositioning, restructuring and development rather than relying on market growth. It also suggests the need for a contrarian approach, seeking value in out-of-favour markets and sectors. Overall, the challenge is to use the deleveraging process in our favour rather than becoming a victim of it.

William Hill  - Schroders
The good news is that investors in real estate appear to have not been put off the asset class despite the loss of significant value in the downturn. Perhaps this is a reflection of disillusionment with other investment types and the fact that it still represents a very small part of institutional portfolios. However, I suspect there will not be another chance if the mistakes that have been made are repeated. For example, one obvious lesson to be learnt relates to the use of debt. Investors and their fund managers have often failed to appreciate the risks inherent in the capital structure of their investments. For some, the increase in volatility of portfolio returns caused by leverage has been a concern.
However, the debt lesson is more about understanding the terms on which debt has been procured and the ability to manage the portfolio around that. Investors and managers are now seeing the effects of breaching lending covenants, not being able to refinance and finding that the cheap debt that looked so good is now a nightmare CMBS structure with bondholders not in the least bit sympathetic to the investor.

Another lesson is understanding the terms of the investment vehicle that is chosen. Fund governance, transparency, difficulty in trading the holding and alignment of interest are all areas where investors have fallen out with their managers. Fund structures are a minefield and the lesson surely is for the industry to come up with an approach that standardises many of the terms. There will be benefits for the manager and investor alike, as it would reduce time to and in the market, lower set-up costs, improve liquidity and set a governance framework that is fair to both parties.

In the future, I see the biggest challenges for real estate investors as getting the right side of both the effects of the global de-leveraging and the flood of environmental legislation aimed at reducing carbon emissions.

Ric Lewis - Tristan Capital Partners
The greatest lessons that can probably be learned from real estate's great boom of the noughties and the bust of the credit crisis are to avoid the ‘madness of crowds' and to recognise true intrinsic value.

So many people got carried away with the hunt for assets and the ratcheting up of returns through leverage that they lost sight of the links between the logic of the investment and the fundamentals of the real estate and capital markets. It was the inability of our research to support the then prevailing market returns, on either of those key points, that led us to liquidate a large part of our European portfolio a couple of years ago, even though some investors disputed our rationale. There is a great danger in buying ‘momentum' - in a boom, or currently in a thin and volatile market. It is easy to be caught out by classic "value traps."

But now it is important to address the exceptional investment opportunities that are emerging. At Tristan Capital Partners we believe we may be entering an era where trend economic growth falls below recent historic levels, limiting the potential for market-driven repricing. We expect that the combination of a risk-averse financing community and weak underlying fundamentals will mean a risk premium continues to be attached to assets that need active managing.

With the spread of core-plus investments - involving some element of leasing risk - at the highest level for the past 20 years over core assets, we see an opportunity to open this investment style from next year. Investors should be able to earn attractive risk adjusted returns from core-plus that could even exceed those seen early in this decade.

George Jautze - ING REIM
The most striking lesson to be learnt from the real estate boom and then crash, for me, is the danger of the ‘competitive greed' for returns at the corporate level, rather than at the personal level. I think the culture of sky-high compensation and bonuses was a symptom of the unsupportable risks taking by companies on the basis of cheap money that led to the commercial property market's asset bubble.

As Citigroup CEO Charles Prince famously said in the Financial Times in July 2007, just prior to the onset of the credit crisis and at the height of the private equity leveraged buyout frenzy: "As long as the music is playing you've got to get up and dance."

Well we've certainly been doing the tango in real estate investment since our new dance partners from the private equity world took to the floor in 2004-05 with buckets of capital. This was a key tipping point because these investors were looking for short-term alpha, or market outperforming returns, which was a very difference source of capital from traditional long-term buy-and-hold institutional real estate investors.

The perception that the dance would go on for ever and the low-cost financing available, particularly via securitisation in the CMBS market, combined to drive down yields everywhere. When yields for commercial property in Central Europe, for years at around 10%, were rapidly driven down towards 6%, it was clear risk pricing had gone out of the window.

Thus we learned our second big lesson, that diversification of risk in portfolios didn't work in these circumstances, as all markets became correlated, and that our old models were broken. So what is the great challenge now facing us?

I think our greatest problem will be replacing debt with equity, due to the much reduced bank financing that is likely to be available for real estate investment. Bank debt may be replaced by mezzanine-type finance from other parties such as private equity and hedge funds. Or the sovereign wealth funds, with their huge reserves, could become a leading source of equity. Whatever the outcome, it is clear that leverage-driven high returns are gone for the foreseeable future.

Joanne Douvas and Tommy Brown - Clerestory Capital Partners, LLC
It's hard to extract just two nuggets of wisdom from the annus horribilis we've experienced. We all have our don't lists: don't run out of cash, don't over-commit fund capital, don't cross-collateralise. And there's an equally important do list: do the right thing, do be transparent, do communicate regularly, do be nice to your bankers.

We all yearn for an easy-to-read playbook for the hard lessons learned, to help us avoid reliving them. But as investors, we take a different approach, continuing to rely on our two core principles:

Focus on the durable competitive advantage. Focus on the quality and integrity of management.

These, to us, are more fundamental than any do or don't.

Approaching the end of the decade, real estate investors appear to be slowly stepping out, but the way forward is still uncertain. There remain so many big variables - for example, the tension between US fiscal policy and monetary policy, or the ability of the US and European governments to flush the system of bad real estate loans.

Given these and other headwinds, we would sum up the number one challenge for the 2010s very simply: Know when to move on. For real estate owners, that means recognising when there is no more equity to be had in a deal, and that perceived option value may not outweigh opportunity cost. The sooner debt and equity stakeholders recognize losses and move ahead, the sooner the real estate industry will be on the road to recovery. Until then, we will all muddle along until external events compel decisions one way or the other.

Claude Angéloz - Partners Group

Lessons learned:
Real estate remains a sticks and bricks business.

Real estate remains a long-term asset class. Managers and their teams need to have a five to 10-year perspective, which needs to be reflected in their incentive and retention schemes and how they align their interests with their limited partners.

Always ask yourself what the best instrument to access a market is, using the full range of instruments (primaries, secondaries, directs), as the attraction of these will vary depending on market cycles. Right now, for instance, we see nowhere with better value than secondaries.

We expect 30-50% of the managers to get squeezed out of the market. Post-crisis, however, we expect even more managers globally than before the summer of 2007.
Each market cycle offers opportunities. Today we see them in the secondary market, on the debt side in the developed markets, and we remain bullish for Asia-Pacific and the emerging markets for the mid to long term.

Each market and its segments has its own cycle. Global diversification and diversification along the entire risk/return spectrum continues to pay off.

Some markets, eg the UK/London market, are already getting expensive again. Other markets internationally can offer better value.

The number one challenge remains the same: how to earn the best risk-adjusted returns for your investors. To achieve that we need to get our macro picture and relative value assessment right, identify the best local real estate developers and managers worldwide, and get access to the most attractive investment opportunities.