Although Europe's first generation of non-listed real estate funds are coming to the end of their terms, the impact on the market is unlikely to be severe, especially if investors and managers work together efficiently. Steve Hays reports

Europe's vanguard generation of modern non-listed real estate funds will pass  significant milestones over the next five years as investment vehicles with a total gross asset value of €66bn come to the end of their first investment cycle, a major research report from industry association INREV shows.

"The fund termination study shows that there is potential for a wave of new investment opportunities stemming from these closed-end funds as they end their terms," Lisette van Doorn, INREV chief executive said.

"However, our research also indicates that the various termination options available to investors and managers mean the bunching of fund exit dates can be dispersed to moderate the peaks that are now concentrated between 2009 to 2011," she added.
The INREV fund termination study, carried out by Finnish consultants KTI, concentrated on a sample taken from a universe of 131 European non-listed closed-end real estate funds due for termination between 2005 and 2010 with a gross asset value of €52bn. The sample analysed via a survey comprised 51 funds with a gross asset value of €13.5bn.

Termination options for non-listed funds include liquidation of the fund's assets, extension of the fund's life, rollover of the assets to a new fund, or converting the  fund to a listed company  through an initial public offering (IPO).  The study found that 59% of core funds due to terminate between 2007 and 2010 are likely to continue the fund (extend or rollover). It is this high number of continuations, expected to be chosen by fund managers and investors, that will contribute to the moderation in the terminations peak predicted by the INREV vehicles database.

The modern non-listed real estate funds industry was essentially created as a recognisable asset class in the mid-1990s when modern investment portfolio techniques honed in equities and bond funds began to be applied to bricks and mortar.
With the collapse of the ‘cult of equities' following the bursting of the bubble in 2000 and the recognition of the portfolio diversification benefits of real estate to institutions - with its long income streams and a risk/reward profile between equities and bonds - a rising wall of money flooded into property funds both listed and non-listed.

INREV itself was established in Amsterdam in 2003 to bring transparency to the European industry and has since launched a whole range of initiatives, from corporate governance, due diligence, fund reporting and fee metric guidelines to performance benchmarking and a new NAV (net asset value) calculation model.

Since the turn of the century, the European non-listed real fund industry, cushioned by low global interest rates and reviving economic growth, has produced strong investment returns and grown to a €400bn market. It is now that managers and investors in closed-end vehicles have to make termination decisions on the first wave of these non-listed funds.

The style of the fund is a major factor in determining what termination decision a fund will make. While the majority of core funds are choosing to continue, this is not the main choice of value-added and opportunistic funds higher up the risk spectrum where 67% and 100% respectively are planning to liquidate at the end of their lives.

INREV defines core funds as those where the assets provide stable income returns which are a key element of the total return. The overall return target (post tax and fees) return is up to 11.5% a year, with a permitted capital leverage (borrowing) ratio below 60% of gross asset value.

Value added funds' returns are driven by a combination of income and capital return with a target (post tax and fees) return of between 11.5% and 18.5% a year, with leverage between 30% and 70% of gross asset value.

Opportunistic fund returns are driven primarily through capital return and have a target (post tax and fees) return in excess of 18.5% a year with leverage in excess of 70% gross asset value.

"Investment style is obviously the main determinant in whether a fund is being liquidated or rolled over to a new vehicle and in current favourable market circumstances many fund managers have tried to bring the investment decision forward. Office funds in particular are trying to take a decision before the next downturn," Van Doorn said.

She added that after a period of generally solid performance, the strong investor demand for core funds meant that most are choosing to continue the vehicle, either via an extension or a rollover. In value added vehicles the whole portfolio may be transferred to a new core fund after the assets have been stabilised, or at least the capital tends to stay within the real estate industry.

Continuation also saves the investor having to repatriate capital and then find another investment opportunity. This is particularly the case for high-quality core investments which are scarce in the market. It is the nature of the higher-risk opportunistic funds that assets such as developments or redevelopments are sold off during the life of the vehicle. Many of the funds that went in early into the emerging Central European markets, for example, are now selling on to core and value added type managers.

"Central Europe was considered an opportunistic market in the run-up to these countries' entry into the EU. Because so much capital was chasing the assets there, yields came down very, very, quickly and brought forward the chance for opportunistic funds to achieve their return targets in these countries," Van Doorn added.

The study also interviewed a number of industry participants, many of whom were confident that in the long term there would not be a major market impact from the peak in funds terminating up to 2010. However, 80% of respondents to the questionnaire believed that the peak would have some impact in the short to medium term. This includes a small increase in market liquidity as well as in the size of the listed and non-listed property sectors, but it was clear that respondents to both parts of the study found it difficult to separate the impact of fund terminations from other factors affecting the market.

There was a consensus that the choice of termination option will be determined by the market conditions at the time of decision making. Interviewees in general made the assumption that the European property investment market will perform fairly well in the short term and that while the top of the cycle may have passed by 2010, demand will remain strong. If this is the case, market participants think that more funds will extend or rollover, rather than liquidate, and the properties released will be easily absorbed by the investor appetite for real estate.

The impact of fund terminations will be further softened as fund expirations are taking place in different parts of Europe, which are at different stages in the real estate market cycle.

For example, the UK appears to have passed the top of its cycle, which will make it more difficult for managers to convince investors to extend the fund or to roll it over.
In addition, some investors in the UK have been heavily invested domestically in single-country funds and might now wish to reallocate the capital in order to expand their investments into both Continental Europe and outside of Europe. Transaction prices, however, might not be affected as there remains strong demand from pan-European funds.

Some 67% of respondents in the INREV survey thought that repatriated capital from funds choosing to terminate would remain invested in European non-listed closed-end funds.

However, 88% also thought that some percentage of the repatriated capital would be transferred to funds investing outside Europe in either listed or non-listed entities, particularly in the dynamic Asian real estate market. There may also be some reweighting within European property markets - mainly between the UK and the Continent - stemming from the fund terminations.

"The decision then comes back to listed or non-listed, especially in Asia, because the non-listed market is not that well developed there yet. Within INREV's membership there are many funds of funds that want to go to Asia and the pace seems to be going even faster that it did in Europe.

Developments that took place in Europe ten years ago are now taking place in Asia within three years. Whereas Europe first built-up a non-listed investment market and then funds of funds, in Asia these developments seem to be occurring together," Van Doorn said.

The INREV study also revealed that only a very few funds are considering an IPO as an exit option. This is perhaps because investors opted to invest in non-listed vehicles for their particular characteristics of closer correlation to the underlying property market and more investor control, and so they have little desire to end up in a public real estate portfolio. Some property equity analysts, however, have viewed the non-listed funds sector as a possible key source of IPOs to drive the future expansion of the listed Real Estate Investment Trusts (REITs) market in Europe.

While fund managers think that exit opportunities via the listed market may have disappeared for the moment, they also believe they could return in the medium term and therefore some funds terminating closer to 2010, might still choose an IPO.

Whichever route they choose, the study highlights the importance that the termination decision process is a collaborative process between both parties. "It makes sense that both investors and fund managers completely align their interests over a fund's termination. It is in both parties' interests that the assets have reached maturity and that they sell off in the right market circumstances, otherwise the fund manager will lose out on his performance fee and the investors will not achieve the maximum from their investments," Van Doorn said.

Most respondents in the study agreed that market conditions would be a key determinant in the timing of fund terminations and a common assumption underlying this appeared to be that the strong capital flows into the industry of recent years are set to continue, Van Doorn said.

"I think we've seen in the sudden evaporation of trust in the banking sector, due to the fallout from the credit squeeze, that market psychology can turn very quickly, contrary to people's expectations. It's clear from the INREV study that respondents are assuming the strong capital flows into the non-listed real estate sector will continue, but investors and fund managers should also prepare for future market conditions if this turns out not to be the case," she concluded.

Steve Hays is a founding director of Bellier financial based in Amsterdam