Joe Walsh reports on MIPIM’s second annual summit for institutional real estate investors that took place in March
At MIPIM 2013, REED-MIDEM convened key institutional real estate investors from across the globe to discuss the challenges and opportunities associated with investing in today’s dynamic global real estate market. The event, RE-Invest, tackled current issues head on with a frank and open dialogue among the participating thought leaders. The following summarises the substance and insights that transpired.
The thought leaders at the event were institutional real estate investors, including pension funds, life Insurance companies and sovereign wealth funds. They represented geographically diverse capital sources from Asia, the Americas, the Middle East and Europe. They commonly seek real estate investments as an opportunity to diversify their overall portfolios and for inflation protection. While they traditionally prefer to invest in core assets, high demand for these assets and a large influx of capital into core markets has priced many investors out of the market. They now seek better investment opportunities by expanding geographically and buying property beyond traditional core investments.
During the event, investors had the opportunity to share their insights at roundtable discussions on topics including strategies most attractive in the current environment, real estate debt as a possible alternative to traditional property investment, and the best investment approaches and structures to employ today.
The opening of the 2013 RE-Invest summit centred around managing uncertainty in the current market and unearthing strategies and opportunities that would yield attractive returns. The opening speaker posed the question whether current economic headwinds were changing into tailwinds and if investors are finally ready to take on more risk in their investments. Investment demand for core real estate continues to be overwhelming with some speculating that risk is being over-priced and returns are being sacrificed unnecessarily. Private-equity fundraising has been slowing despite an increased allocation to real estate investment. Simply put, money is not flowing to funds.
Investors have a strong preference for control of their investments.However, the limited size of their investment teams makes managing a diverse portfolio challenging. The prevailing direction, then, is for joint ventures and club deals, which provide greater control, alignment and cost efficiency for large investors.
They are also seeking better investment opportunities by expanding geographically and by pursuing value-added and other strategies.
Topic 1. Identifying the best investment strategies. The first topic for discussion sought to identify strategies that are most attractive in the current environment, including whether to invest in core or value-added real estate, and whether to do this through real estate funds, listed securities or debt.
Core assets are generally overpriced
There is a perception of low risk in core real estate investment, but core may not be the safest strategy if an investor overpays for the asset. Some participants suggested that investors tend to overpay when long-term leases are present, and fail to adequately consider the fundamental quality of the underlying asset or building.
Even if they have quality assets fully leased at the time of purchase, the property will require re-leasing at some point. The asset itself must be strong on its own merits, and not only have a strong current rent roll. Future rental growth may be difficult to achieve for core assets having minimal vacancy and high rents at acquisition.
Paying too much for a core asset can create problems for later down the line when the investor comes to make an exit. While the current low-interest-rate environment may be compressing cap rates, in the longer term, as interest rates return to more normal levels, the spreads on exit cap rates may increase, undermining the total return on investment.
Having simply been priced out of the market, several investors have stopped looking at core assets and are instead looking for opportunities to take advantage of the bifurcation in the market between primary and secondary assets and cities. Others continue to pursue core investments, but only in the US.
Most participants see good opportunities beyond the traditional core assets in core markets, exploiting the price differential in secondary markets. The next wave of opportunities seems to be in acquiring core assets in more secondary markets, or acquiring assets presenting a value-added opportunity in core markets.
In moving away from core investment strategies to find better pricing in the market, two basic strategies emerged: focus on value-added assets in core investment markets in primary cities, or acquire core quality assets in secondary markets.
Within the primary gateway cities, value-added investors are looking for opportunities to rebuild and reposition tired assets back to core quality. They look to acquire assets that may need some limited capital improvement and releasing, but would otherwise qualify as a core asset in that market. In doing so, they can earn higher returns from a value-added strategy and, in the end, own a core quality asset.
For value-added opportunities in second-tier cities, perhaps the most critical issue is identifying those cities with solid economic fundamentals. As Western economies slowly recover, investors seek to identify the economic sectors poised for strong future growth and then identify those cities that are poised to benefit from those growth sectors, resulting in strong tenant-demand growth over the long term.
In both cases, the key consideration is to identify locations that have a long-term value.
When selecting assets within a city, the focus is on locations with long-term demand drivers or locational advantages that cannot be duplicated. When selecting secondary cities, the focus is on markets where fundamental economic forces are fueling long-term growth and demand for space. In both cases, there will always be tenant demand for the space when lease turnover occurs.
Although attractive, value-added is challenging
While most of the institutional investors reported an interest in expanding value-added strategies, they also faced challenges in being able to execute the strategy.
One common challenge for participants was a lack of team size and expertise which is necessary to execute value-added strategies, particularly when extending focus beyond traditional gateway markets.
With the desire for increased control, which will be discussed in greater detail later in this report, and the inherent challenges of executing a value-added strategy, executing that strategy requires a much larger investment team. Given the structure and internal budgets of many pension funds, growing their internal teams is not an option for many participants.
Many thought leaders are turning to co-investment opportunities through joint ventures, where a local partner has the investment platform and local expertise needed to execute a value-added strategy and has significant direct investment so interests remain aligned.
Participants advise caution in pursuing value-added strategies. While no consensus emerged regarding the definition of value-added, the following guiding recommendations were offered.
• Participants do not invest in markets where a lack of transparency is an issue, because it is not possible to underwrite the risk that exists in these markets, and it is unlikely that they will be paid enough for the risk borne.
• Most investors prefer to avoid distressed assets, but they do like to invest in high quality assets where it is the seller that is distressed.
• Selecting a joint venture partner and structuring an agreement are critical for success, as is discussed in more detail later in this report. Perhaps the largest challenge is in identifying a joint venture partner with the operational expertise as well as an aligned investment strategy. The preference, not surprisingly, is for best-in-class operators.
Topic 2: Real estate debt strategies. Some of the RE-Invest participants were asked to evaluate real estate debt strategies, considering: whether real estate debt offers a better risk-adjusted return than traditional equity investments; where those best opportunities may be in European real estate today; whether senior, mezzanine or distressed debt offers the best opportunities, and whether debt should form some part of a real estate portfolio, or as a separate allocation.
In general, RE-Invest participants did not represent financial institutions and were not involved in debt investment. Reasons for avoiding debt investment are as varied as the participants in the conference, ranging from the tactical – such as a lack of resources, staff or expertise, to the strategic, such as a portfolio strategy to earn fixed returns through other asset classes.
For non-financial institutions, the regulatory environment required for senior debt lenders is a barrier to direct lending. Those investors that are involved in debt investment do so mostly in junior mezzanine loans. It is easier for most participants to migrate from equity to junior and mezzanine debt, and the absolute returns are favourable. Rather than trying to pursue senior debt lending in-house, these investors may be more inclined to invest in a banking platform.
In Europe, mezzanine debt is currently offering a better return than equity, but the concern is focused on how long this opportunity will last. Access to cheap capital in the senior lending space has both a positive and negative impact on institutional investors’ investment strategies, and we are now seeing them adjusting these to include more junior and mezzanine debt investment.
One debt strategy that was suggested was to offer junior or mezzanine debt on high quality assets that investors would be inclined to own within their portfolios. Mezzanine debt would offer a higher return than senior debt and in the downside case of default, you could own an asset that you would like to have in your portfolio.
Among those participants who were interested in debt strategies, purchasing or originating junior mezzanine notes in North America seems to be an attractive approach. Others are beginning to look to Europe for these opportunities as well.
In terms of geography, the panel favoured investing in real estate debt in the UK, US, Germany and the Scandinavian countries. The UK was a focus for junior mezzanine debt because the legal structure is friendly for creditors. Investors are very wary about investing in real estate debt in markets where regulation or legal structures favour equity investors.
The participants were in general agreement about avoiding investing in debt in France.
Acquiring distressed debt was not an option for most of the participants. Institutional investors are generally not interested in distressed debt because the assets are typically distressed for a reason and would not qualify as a type of assets they consider.
Participants observed that European banks have been able to access liquidity from governments and so are not inclined to dispose of distressed debt, but rather work out loans over many years, spreading the losses out over time.
The thought leaders were in general agreement that commercial mortgage-backed securities (CMBS) investment would continue to increase in the near future.
Topic 3: Identifying the best investment approaches. Several of the roundtable discussions focused on identifying the best investment approaches. Topics included consideration of approaches and structures such as direct investment, joint ventures or club deals, real estate funds or funds of funds, and listed real estate securities or REITs. In particular, the investors considered the advantages and disadvantages of direct deals and joint ventures versus pooled real estate funds. Finally, investors discussed the best alignment of interest with investment partners.
Simply put, there is no single best approach to investment that emerged from the discussions. The range of viable investment approaches is as varied as the investors themselves. The optimal approach depends on many factors, including – but not limited to – duration, hurdle-rate requirements, mandates from the institution, regulatory environment within the country of origin, tax issues with investing in other countries, and the current relationships, investments and partnerships in place providing a base of business and expertise. The need to pay cash distributions from the fund is another fundamental consideration in the strategy.
However, there was clear consensus among the participants that direct investment and joint ventures are preferable to pooled real estate funds. The investors expressed a preference for more direct investments after the financial crisis as they wanted to manage investments more actively. The shift towards more direct control over investments is continuing, but many of the investors continue to hold assets in fund structures that were put in place prior to the global financial crisis.
Direct investment may be the ideal approach to investing in core and core-plus markets and assets, for deploying large amounts of capital in single transactions, and for controlling the investment. Direct investment is most effective for large investors on large deals, and for smaller investors on smaller deals, as makes sense considering the large scale of investment mandates for the former, and the capital constraints for the latter. Investors commonly target only the top-tier cities globally in order to best deploy large amounts of capital and direct investment within active, liquid markets.
Compared with before the global financial crisis, investors are now far less inclined to take a passive role within an investment structure. They are taking a more strategic approach with partners to find creative opportunities through more complex deals, or portfolio deals.
They are willing to improve certain assets into future core assets through direct investment, value-added strategies, because current core yields have compressed making direct acquisition of core unattractive.
Other participants are exploiting this bi furcation of pricing in the market, finding asymmetric returns in the wide spreads between core and non-core assets. Pursuing these strategies requires flexible mandates.
However, with the limited in-house resources expressed by a large number of participants, managing the process and assets directly is not feasible for all investors. As a result, they are tending to prefer joint ventures and, where necessary, funds.
With international investing, most agree that having a domestic partner is a must in order to invest successfully in a foreign country.
Alignment of interest with partners
As discussed, most of the investors want as much control as possible, but lack the in-house team with local market knowledge in all regions targeted and operating expertise necessary to execute the strategy. Instead, they are moving toward joint ventures with, preferably, a maximum of two like-minded partners.
They recognise that just because partners may be aligned at the beginning of an investment or relationship does not mean that they will remain aligned in five or 10 years. Like-mindedness tends not to persist over long periods of time, as interests diverge.
Therefore, these institutional investors place a heavy reliance on governance structures and the type of partner with whom they do business. The preference, not surprisingly, is for best-in-class operators.
Some of the strategies that the investors are using to better align interests with partners include:
• Using probation clauses with certain targets, as well as replacement rights if hurdles are not met, depending upon the investment vehicle;
• Using accelerated carry clauses, ‘claw-backs’, and a ‘true-up’ near the end of fund so undue risk is not incurred to catch up targets;
• Calculating ‘promotes’ based on actual sales price not valuations;
• Structuring partnerships that do not rely overwhelmingly on fee income, but rather on ensuring the assets themselves perform well;
• Limiting management fees to cover only current management costs, even if that means a greater carry for the general partner, in order to limit the incentive for the manager to hold fund assets to maintain the fee income stream rather than sell the assets.
Several participants expressed the view that there is no evidence that co-investment stakes create better performance, although they do create alignment.
For some, a significant equity investment by the partner is a requirement for alignment, and accountability, and alignment of interests becomes questionable anytime a third entity comes into the equation. Use of the traditional investment manager is precluded for participants who use this approach.
Alignment of objectives also means gaining exclusivity and developing a pipeline for future investments. Constantly searching for new deals will exhaust in-house resources, so building partnerships that provide an ongoing investment stream is an important goal.
Fund model is problematic
Most investors find the pooled-fund investment approach to be problematic in several critical areas. Foremost is the lack of control for the investor in most structures, preventing the investor from direct control of the assets being acquired. But, additional concerns were expressed regarding the level of debt employed to achieve returns and incentives for managers to hold assets for the fee income stream rather than exit the investment on a timing that is optimal for investors.
For opportunistic strategies, the carry structure can make sense, but it only works in rising markets. In declining markets, the manager has little or no equity in the deal, and so is less likely to sell the asset and maintain the fee stream income.
A role for funds
Pooled real estate funds are clearly out of favour; however, they can play a valuable role in certain circumstances. For example, funds can provide a vehicle for exposure to emerging markets with a relatively small investment. For large investors, the initial investment can build institutional knowledge and relationships in that market which can be used to launch a direct investment platform at some time in the future. For smaller investors, it can provide access to growth in emerging markets where direct investment is not feasible and publicly traded real estate securities may not exist as an option.
With large fund managers, individual institutional investors have less influence. Some thought leaders also expressed scepticism that large funds can deploy all of the capital they raise wisely and effectively. Investing with smaller developers and managers where employees have significant investment into the deal was preferable. However, finding reliable, well-qualified partners with suitably aligned strategies remains a significant challenge. Wherever possible, find like-minded investors, preferably other institutional investors with local market expertise and a well-qualified team to execute the strategy.
Along these lines, several of these institutional investors expressed an interest in developing in-house talent. Acquiring an ownership interest in a management company may be an alternative approach to aligning interests with an established and skilled team.
Public real estate investment
Real estate investment trusts (REITs) and other listed property company securities are effective approaches for quickly achieving geographic diversification, and to provide liquidity. The liquidity attribute can be especially appealing to smaller institutional investors and those whose remaining portfolio is primarily invested through funds that do not offer much liquidity.
No single strategy can meet all investors’ needs, but important trends are emerging. While core assets continue to be in high demand and are priced accordingly, investors are looking beyond core investment in the major global markets to identify better pricing and returns on value-added strategies.
Achieving greater control over investments than the traditional fund structure provided is a clear mandate among most institutional investors. However, given the limited size of the investment team at most of these groups and the broad mandate for geographic and asset diversification, investing exclusively through direct investments is unrealistic, forcing investors to pursue partnerships and joint ventures.
As previously mentioned, investors had a clear preference for direct investment or joint ventures with substantial control. The more challenging question is structuring the level of control and alignment of interests with fund managers. Simply put, if investors want influence on decision-making, they will need to avoid club deals and pooled funds.
One preferred strategy is to invest directly in domestic markets and invest with partners in international markets. Institutional investors with a small real estate allocation are best advised to invest in listed property companies or unlisted funds (as long as liquidity is not a critical issue).
Joe Walsh is a faculty associate at the Wisconsin School of Business