Regulatory changes and investor demands for different structures and more transparency from managers will shape the development of real estate investing in the years to come, says Simon Redman
The years leading up to the financial crisis were a time of growth for real estate funds, especially in Europe. It was during this period that the fund industry came of age and developed from a largely domestic enterprise to an international one as demand for real estate increased. The result was the dramatic growth in real estate funds, as the chart illustrates.
The demand for and growth of real estate funds was due to the convergence of:
While the first two points account for an increase in real estate demand, the second two account for the growth in property funds. Another factor is that real estate funds provide access to geared returns. Many pension funds are unable to use debt as part of a direct investment strategy, but funds provided a way of satisfying the demand for ever higher debt driven returns.
Rapid, debt-fuelled real estate investment became a bandwagon with many real estate brokers, investment banks and boutique advisers turning themselves into ‘investment managers'. This rapid growth had many positive developments, but also it also resulted in an industry bubble, the aftermath of which will have an effect on the future shape the industry.
The future basis for investment fund selection may well change. Investors during the boom often based some of their selection criteria on identifying the following attributes: boutique, specialist firms; narrow focused strategies; carried interests, and co-investment.
The rationale was that these factors would identify ‘best of breed' managers whose interests would be aligned with the investors. In a rising market with many funds to choose from it can be argued that these factors did provide good selection criteria. However, it is worth questioning whether these criteria worked in a downturn or are appropriate for the future.
The financial crisis resulted in few funds being launched in 2009, while many existing funds had to sort out problems. Although the signs are more positive for the industry during 2010, the number of fund launches expected is small compared to the market peak.
Notwithstanding recent reduced investor activity, demand for real estate remains positive. The 2009 European Institute of Asset Management Survey (EIAMS) states: "Real estate is one of the key beneficiaries of a major shift in asset allocation preferences among European institutional investors... Aside from cash, which has increasingly expanded its share of investor portfolios, fixed income and real estate appear to be the big winners."
The positive sentiment is also supported by figures from AREF showing £3.34bn of commitment to UK real estate in Q4 2009.
One reason for real estate's enduring popularity, even in the aftermath of the most significant global downturn, is the appreciation that it has the potential to provide diversification - as highlighted by the different timing and magnitude of performance in the UK, continental Europe and the US.
Many investors with an international view recognised these attributes and not only mitigated much of the impact of the downturn by avoiding markets such as the UK at the right time, but also invested in the right countries at the right time.
Continued interest in real estate does not necessarily mean a dramatic increase in fund launches, though, given the combined requirements to refinance existing debt and focus on more core strategies.
Regulatory changes such as the Alternative Investment Fund Managers Draft Directive (AIFM) could have an impact on some managers. Although the first draft would have had a very onerous effect, the suggested revisions will be less so. The ultimate provisions of the directive are unlikely to have a significant impact on managers used to operating under the scrutiny of financial authorities, but the smaller, less well-resourced managers may be affected.
Lastly, investor preferences and what they demand from fund managers will probably have the most material change. For example, there is the stated interest from some to participate only in investment clubs where they have some influence. However, necessarily this route is the preserve of the largest investors.
Larger investors, for whom club deals are not an option, may seek to invest in funds that do not provide full discretion, but this form of investment only works with a relatively small number of investors. If an investor group is too big, decision-making becomes unwieldy, negatively affecting the management of the fund.
Investors in fully discretionary funds should have confidence in the fund manager. The ‘black box' approach - seen too often in the past - where managers fail to be transparent and open about their activities, will not instil trust. Managers should embrace a culture of transparency and accountability.
Investors, on the other hand, may have to accept a smaller number of funds to invest in, but the ones they choose should be with managers who
Investment managers should recognise that business success comes not only from performance but also from serving the needs of investors.
It is the combination of the two that can lead to long-term success, not one in the absence of the other.
Simon Redman is senior director, head of product management at Invesco Real Estate.