Michael Hornsby updates on INREV Open End Fund Pricing paper
Open-ended real estate funds typically provide access to large, diversified portfolios aimed at providing stable, long-term returns with a moderate level of risk. They also provide a certain degree of liquidity.
However, one of the challenges is ensuring that there is a fair mechanism to share the effects of real estate transaction costs equitably. The industry has developed different pricing mechanisms to address this concern, but not without encountering some misunderstandings and controversy.
As things stand, investors and managers face several different pricing methodologies. While we have seen a degree of consensus develop within particular geographical clusters, currently there is no consistency at a global level.
The primary objective of a well-constructed pricing policy is to ensure that the interest of all investors is fairly considered and, so far as is possible, to reflect the reality of transaction costs. At the same time, these mechanisms need to be simple, transparent and potentially include an element of responsiveness to the variability in underlying fundamentals.
The good news is that progress is being made to understand the issue, recognise that different fund products have different needs and, in some cases, improve practices, and, most importantly, to help investors understand the topic. The broad ambition is to create a more structured and common approach to pricing methodologies in the best interests of investors – to establish a set of principles that drive transparency.
For the past 18 months, the European Association for Investors in Non-listed Real Estate Vehicles and the UK’s Association of Real Estate Funds have led an initiative to change the status quo. The work has been driven by a focus group of investment managers and consultants drawn from both associations’ memberships.
To date, the most visible output from this exercise has been the publication of an industry-wide consultation paper, Open End Fund Pricing. Despite its deceptively simple title, the paper is, in fact, a thorough review and assessment of the main pricing methodologies used in the industry.
Through rigorous analysis, the paper looks closely at the relative merits and disadvantages of single pricing and dual pricing – and their many variations. Single pricing means an investor, or an existing shareholder, can buy and/or sell units at a single defined price. This approach is common in the US.
In the US, the impact of transaction costs when written off is generally viewed as immaterial due to the underlying nature of dealing in real estate in this market. The same is not true for markets such as Europe and Asia, where transaction costs can be significant and vary greatly from one jurisdiction to the next. So price adjustment mechanisms are required to fairly attribute these transaction costs between all vintages of investors.
In some large domestic markets, such as the UK, transaction costs, although significant, are predictable and easy to estimate. In these situations, a simple fixed pricing spread can be highly effective, although it should be capable of accommodating change if market conditions move.
In more internationally diversified funds in European and Asian markets, transaction costs are not only significant but vary considerably from deal to deal. A common approach by many managers to protect long-term investors from the diluting effect of transaction costs over time is to capitalise and amortise these costs over a set period, generally five years. This can be highly effective.
One of the potentially better suggestions in the paper is for a dynamic model incorporating the best qualities of all existing practices. The model focuses on tracking and recording historical acquisition and disposal costs. For instance, taking a five-year average of acquisition and disposal costs and applying this spread to subscription and redemption pricing, respectively.
Although this paper may not provide an immediate solution, it helps to point us in the right direction.
Ultimately, regardless of where investors are domiciled, it is critical they understand that appropriate pricing mechanisms are a force for good. And managers need to ensure they’re thinking through the pricing issue and designing products that secure equity between investors.
Michael Hornsby, partner at EY and board member at INREV
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