In March, INREV launched its next-generation fund style classification and an accompanying style classification guide - -innovations that aim to increase transparency across non-listed real estate funds. Lonneke Löwik explains

INREV developed its first style framework in 2004. It used the two measures of target leverage and target internal rates of return (IRR) to classify non-listed real estate funds as core, value added or opportunity. At the time this was a helpful first principle offering useful guidance.

However, this approach had proven not to work through the changing market conditions. The IRR and leverage objectives of funds shifted over time with the state of the market and availability of credit, leading funds to drift across the defined boundaries. The increasing sophistication of the industry and availability of much richer data on live funds have made it possible to develop a more comprehensive approach to classification - one that is workable, robust and enduring.

The new INREV Style Classification and INREV Style Classification Guide Tool are the results of extensive research and development. Since 2007, INREV's Styles Working Group has continued to monitor and review the original framework. It has also guided the rigorous statistical analysis carried out first by the CASS Business School and, latterly, Reading University. INREV members contributed to the research with data collected from over 200 funds, through workshops and on-line consultation, making this the most extensive exercise of its type to date.

A ‘bundle of risks'
Moving on from earlier thinking, the new methodology is based on the notion that style is the result of a bundle of risks, whereas return is the outcome of the investment process and therefore not part of the style classification.

Real estate assets are by nature heterogeneous. Additionally, managers use a variety of strategies in managing their funds. The combination of these factors means that the non-listed real estate sector is affected by many risk factors. However, the new INREV Style Classification is based on just three key risk factors that were found to be the main determinants of fund style.

These factors are:
• An income indicator (target non-income producing investments as a percentage of fund GAV);
• Development exposure (target annual development exposure as a percentage of fund GAV);
• Leverage (maximum allowable leverage as a percentage of fund GAV).
In addition, a core fund must target most of its return from income.

Clearly, these are not the only risks affecting the performance of non-listed property funds but the main determinants of style. As an integral part of the analysis, INREV reviewed risk factors such as country allocation. Despite its importance as a risk variable the statistical analysis showed that country allocation turned out to be a less robust and reliable determinant of style. The scale of this risk depends too much on the individual investor. It is therefore preferable to have a country label next to the style classification, for example French core fund or Iberian value added.

While the key risk determinants of style have been redefined, the new framework retains the existing fund style names themselves: core, value added and opportunity. These terms have the benefit of being simple and clear; they are also widely known and accepted throughout the industry.

Defining boundaries
Each of the key determinants of fund style carries a specific numerical value band which applies to each of the three different fund styles. These parameters are highlighted in the table.

The principle behind this structure is that funds should meet all the boundaries of a particular style. If one of the boundaries is crossed, the fund will be classified as belonging to the riskier of the styles within which boundaries it sits, moving progressively from core to value-added to opportunity.

The new methodology bases a fund style classification on the fund's objectives at the time of its launch. Once defined, the style of a fund is frozen at that point. The new classification is designed only to be applied to funds launched in 2011 or later. Any reclassification should only be undertaken in exceptional circumstances.

Because the new style classification relies on strong empirical evidence on which to base enduring classifications, it should ensure greater resilience to changes in market conditions and less room for inconsistent or conflicting interpretations of fund styles.
Chair of the INREV Style working group Russell Chaplin, CIO property, Aberdeen Asset Management, adds: "This approach is more comprehensive than the style assessment criteria adopted in INREV's original framework from 2004. It not only looks at vehicle characteristics but takes real estate variables into account as well. These three variables are simple and transparent indicators of variation in risk. They are easy for managers to provide, which makes the new approach workable. It is also enduring over time, with clear boundaries that don't shift with the state of the market, as was the case when target IRR was used."

Helpful tools
INREV has also developed the Style Guide Tool to add a further level of information, and particularly address possible boundary challenges that can arise from the use of fixed numerical bands to classify fund styles.

The Style Guide Tool weights the three classification factors measuring the impact of each and then combines them to determine the probability of a fund belonging to one or other of the three fund styles. The higher the probability of belonging to a particular style, the more confidence there will be in assigning a fund to it.

Continuous evolution
The scene is set for style classification to evolve and improve as data accumulate. For example, as new funds are created and incorporated into the analytic framework behind the tool, this will become even more robust while at the same time reflecting the market.
If over time the sample of funds in the INREV Index becomes large enough, it will provide the index with more consistent INREV Style sub-indices for these vintage funds improving on the current sub-indices that are based on self-declared style.

Since their launch in March, the new Style Classification and Style Classification Guide Tool have been being carefully reviewed by INREV's members. So far the reaction has been positive, albeit some market participants voiced concerns about the revised levels of debt, especially for core funds. The new methodology will take time to become fully embedded in the working practices of investors and fund managers.

However, there should be little doubt that INREV's recent work on fund styles classification will enhance overall clarity and transparency in the non-listed real estate sector.

Lonneke Löwik is director research and market information at INREV