The fee structure is only one of a number of tools investors can use to ensure that their manager's interests are aligned with their own. Dirk Söhnholz and Frank Rackensperger explain
Today, the range of indirect real estate investment tools includes REITs and other real estate securities, REIT and real estate security funds, real estate funds of funds, open-ended funds, semi-open-ended funds and closed-ended funds. At the same time, investors have more ways to invest in real estate in a way that will suit their own risk/return-profiles, from the diversified core fund to the opportunistic real estate fund.
In principle, investors will commit their money to a third party to carry out the active management of the property portfolio. This has advantages and disadvantages compared with a direct real estate investment. One potential benefit is the active management of real estate by a market professional. A disadvantage can be less influence on the management of the property portfolio. In order to circumvent this latter outcome, an alignment of interests between the man-ager and the investor is of major importance.
A real estate investor has limited information to evaluate the performance of a real estate manager. In real estate practice, these issues can play an important role, especially for professional real estate investors when selecting and monitoring a real estate investment vehicle.An investor should ensure an alignment of interests with its service provider, which might be achieved via the fee structure, a co-investment by the manager, the documentation of investment guidelines, as well as the form of the investment management entity.A key instrument used to align the interests of manager and client is in the structuring of the fees charged by the fund. Various forms of fees are associated with an investment in real estate funds. A major component are management fees, which in most cases is not a very effective means to align interests. Real estate managers should charge the management fee based on the pure property assets instead of the total assets. This should offer an incentive to the manager to focus attention on the property portfolio. Otherwise, the manager might have an incentive to increase the liquidity position of the fund, for example, which is probably easier to manage but can lead to a dilution of the real estate return.
In addition, the terms regarding the fees based on capital committed and contributed should be examined. Several funds charge the management fee on the basis of the capital committed, which means that the fund manager might receive a relatively high management fee in absolute terms even where the investor has only contributed a small share of committed capital. In this case it seems best for the investor if the real estate manager invests the money quickly. Fees based on commitments do not pressure the manager to invest quickly, which might be beneficial for the investor because there will be more time to assess each investment. Furthermore, the level of fees received by the manager should not be dependent on the valuation of the properties. This will further align the interests of the manager and the investor, especially if performance fees are involved.Performance fees can be either charged during the life of the fund at regular intervals or once, at the termination of the fund. To determine a performance fee, the return of the investment is measured against one or several hurdle rates. The hurdle rate represents the required return often used in the context of the internal rate of return (IRR) above which an investment becomes reasonable. If the return of the fund lies above a certain hurdle rate measured over a specific time period, the difference (= excess return) is split by an agreed division between the manager and the investors. In this regard, the carried interest - the profit share of the manager - becomes due. The respective hurdle rate can be expressed in absolute terms (a certain perfomance number), in relative terms (an index) or in a combination of both (IPD UK Annual Property Index1 + 2.5%).
Although performance fees represent a useful tool to align interests between managers and investors, their effectiveness can be reduced if the hurdle rates are set at a relatively low level in comparison with a realistic performance expectation. The investor should be aware that in the case of a relative benchmark the manager might also receive a performance fee if the net asset value of the fund is falling but still outperforms the benchmark. A contract term should only allow for the manager to receive a fee if the value of the fund increases. Another point to consider is the policy of allocating performance fees between fiscal years. In most cases, it is preferable to make provisions regarding the performance fees based on a high-water mark (the highest value that an investment fund/account achieves). If this is not the case, the manager could take an increased risk before the end of the fiscal year in order to try to reach the benchmark and finally generate a performance fee.However, even a standardised high-water mark can be a cumbersome means to align interests. For example, after a fall in the net asset value, new investors could participate in future gains until they reach the high-water mark without having to pay performance fees. If the fund is heavily focused on the generation of performance fees, it might be reasonable to reset the high-water mark - otherwise, the manager might take increased risks if the net asset value is well below the high-water mark.
Additionally, the split of the excess return between the investor and the manager should be agreed. A low share for the manager (below 5%) tends to provide less incentive for him to outperform the benchmark; a high share of the excess return attributed to the manager (40% or more) can generate a greater incentive for him to take on a relatively high level of risk, especially when the performance fee is relatively high in comparison to the management fee. To compensate for often relatively long time periods before hurdles are reached, catch-up clauses might be established. These result in net profits in excess of the hurdle rate being allo-cated to the manager and the investor disproportionately (80% to the manager and 20% to the investor) until the manager has received a carried interest on all net profits, as if no hurdle rate had existed. This rule is often used with opportunistic real estate funds as an incentive for the manager to achieve a return above the hurdle rate.
Furthermore, the existence of a clawback provision should be ascertained. This provision helps to prevent the manager receiving a higher share of the profits than actually agreed through the carried interest. The latter might arise if the manager receives the carried interest at an early stage in the life of the fund but later the fund loses money. It might also be helpful in terms of an alignment of interests to introduce an absolute cap on the managers' share of profits. This should make it less likely that the manager will engage in risky investments to increase his total performance fee.
Supplementary, other regular2 or ad hoc3 fees including transaction fees4 are also charged. In order to advance an alignment of interests, the funds should document and estimate these fees in detail. High fees - especially in the case of performance fees - must be analysed carefully; an alignment of interests may be achieved by reducing the management fee, for example.
In addition to the fee structure and clear evidence of a good track record, the willingness of a management company to accommodate co-investment can promote an alignment of interests between the investor and the manager. In a co-investment, managers and investors should be on equal terms and managers should be discouraged from cherry-picking the best investments for themselves. Although investors approve of the co-investment model, several aspects need to be considered in more detail. A relatively low co-investment on the part of the manager may not incentivise the manager to manage the fund well. This is especially the case where managers have set up several real estate funds with co-investments where they will presumably concentrate their effort on those funds where they can realise the highest income. The restrictions pertaining to exit of the co-investor and the return concessions to the manager must also be checked; preferential rules for the manager might put the investor at a disadvantage.
A third tool to promote an alignment of interests between the manager and the respective investor is the documentation of investment guidelines. These guidelines may pertain to a variety of characteristics of the fund - the target risk-return ratio, for example. Furthermore, a number of funds limit their real estate development activities to a specific share of the total assets.
Generally, the investor receives an indication of the various risks associated with an investment. This information transparency could be extended to property level as well, as it will provide an indication for investors of the quality of a property investment. Possible conflicts of interest regarding the selection of new properties could be reduced, as the manager not only focuses his investment choice based on potential fees but also based on investor preferences. In addition to this, a fund might confine the investment strategy in terms of regions and sectors and again it is important to communicate this
to the investor, who may well only want limited geographical exposure. Terms that state how much of the assets under management can be invested in one property provide an indication of cluster risks and the diversification potential. If an investor wants to have a limited exposure to currency and interest rate risks, it can be beneficial for an alignment of interests if the fund has defined and communicated its investment limits. In this regard, investors often appreciate if these risks are almost fully hedged as they do not represent the management company's main business activities or areas of competence.
A further aspect that needs to be considered in terms of an alignment of interests between the manager and the investor is the structure of the investment management entity. Generally, investors like to know the management team and their responsibilities. Key clauses can enhance the consistency in the management of the fund.
A further tool of alignment can be created through the introduction of an investment committee with some degree of independence. These largely pure advisory committees are scheduled to meet both at regular intervals and on an ad hoc basis and are usually organised for investors contributing a relatively large investment.
Some fund managers allow investment committees to vote on certain decisions regarding the fund's investment policy. These voting rights must be scrutinised to ensure that no single investor has disproportionately large voting rights; this is necessary because several funds allocate voting rights in accordance with the size of the investment. Additionally, it is if those that have voting rights also have real estate expertise. A further form of alignment is where investors have the right to transfer their own property assets into the fund. This option can be used at the expense of other investors if the fund cannot decide on the basis of its strategic considerations on the quality, the location, the size and other issues related to a property.As a result of the broadening range of real estate investment options, the issue of an alignment of interests between the manager and the investor has increased in importance and has also become more complex. Today a variety of tools exist to reduce potential conflicts of interest. A major focus is on the structuring of the fees as well as on the regulation regarding the investment guidelines. The fund manager must assure a certain information transparency.
Footnotes:
1This index is IPD's flagship service in terms of the number of properties and length of historical coverage - the full index tracks the three market sectors all the way back to 1971.
2Regular occurring fees include custodian fees, property management fees, costs regarding property appraisals and auditing costs.
3Ad hoc fees can include the purchase, refurbishment or development of properties.
4Transaction fees can include financing fees, monitoring fees, advisory fees, break-up fees or director's fees.
Frank Rackensperger is from the real estate division of Feri Wealth Management
Dirk Söhnholz is managing partner at Feri Institutional Advisors
