Investors should scrutinise the management they are paying for to test the appropriateness of the fees paid, says Frank Rackensperger
The current global economic downturn has affected the majority of asset classes, including real estate. After years of large inflows into real estate investment vehicles, recent development has been fragmented. Many real estate funds suffered from heavy outflows, with some open-ended vehicles being forced to suspend the redemption of units because of liquidity problems.
Nevertheless, funds designed for institutional investors and specifically private equity real estate funds still experience capital inflows because they are able to purchase properties at relatively low prices. Especially in these challenging markets, investors put their main focus on the return after costs and thus on fees.
An indirect real estate investment vehicle has to bear a variety of fees. It has to be launched in accordance with the legal and fiscal framework, for example being associated with admission costs, costs of listing on the stock exchange or costs attributed to third parties such as lawyers, accountants and other advisers. Having implemented a real estate investment framework, the management company has the main responsibility over the selection of appropriate properties or land, the marketing of shares and the structuring of the debt financing.
These tasks incur transaction fees, property appraisal fees, sales provisions and debt financing costs for example. The initiator should be keen on offering a vehicle with a lower cost burden in order to realise a higher return after costs. The investor has to check whether the fees mentioned before are carried through the fund vehicle itself.
The company that carries out the management of the fund will usually be compensated through a combination of management and performance fees. The form of these fees is often dependent on the funds' business activity, the risk-return profile, the real estate portfolio allocation and the type of investor.
Most real estate funds view the holding and management of properties as their main business activity. Further activities include real estate development, real estate trading or the provision of real estate services. The activities differ regarding the effort as well as the experience a manager should contribute.
In the case of a project development, a manager has to carry out careful estimates about the market development, needs to accompany the project financing and often has to participate in the marketing of the floor space. This effort can usually be reduced when the fund concentrates on purchasing good-quality buildings in top locations that are fully rented with long lease contracts.
While it becomes obvious that the management effort varies depending on the business activities, it remains difficult to estimate an appropriate amount of compensation. For this reason, the investor should benchmark the fees against those of a comparable peer group.
The risk-return profile is closely associated with the business activity of the fund. It is often observed that the ratio of the management fee to the performance fee decreases with a higher risk-return-profile: Core funds sometimes even exclude performance fees. This raises the question whether the management would neglect the aim of realising an attractive return at the expense of collecting more equity, leading to a higher compensation through management fees.
In addition to that, large funds often do not reduce their fees in line with their economies of scale. As management fees can account for a large share of the managers' compensation, the importance of performance fees as a tool to align interests may be reduced. More opportunistic funds often have a fee structure that is more conducive to the collection of performance fees.
These vehicles presumably provide double-digit returns after costs, with manager fees sometimes being relatively high in absolute terms. Accordingly, an investor should critically evaluate the fees in absolute terms and their composition taking account of the risks taken by the manager and its fund.The evaluation of manager fees needs to consider the portfolio allocation too.
Generally, the management effort increases the greater the number of properties under management, the more lease contracts to be administered or the older the properties and therefore potentially the greater the refurbishment cost. The management effort is also influenced through the employment of third parties in the property selection and management process. An investor's due diligence should also consider the ability of the management to select third parties of high quality as well as cost efficiency.
The sectoral allocation of the fund can affect management effort as well. The effort often increases if the fund invests in a variety of user types. This is because a professional selection and management of properties requires an extensive degree of knowledge, which varies in dependence on the user type.
Regarding the regional allocation, a fund investing in more than one country potentially incurs a higher management effort than a vehicle focusing on a particular region. If a property investment company has already established joint ventures with local partners or even owns offices in foreign countries, the costs of managing an international fund can be reduced. However, it has to be analysed whether this form of synergies actually translates into reduced management fees.
The fees charged by the manager can also vary according to the type of investor. The omission of an issuer surcharge, which is often due with retail funds and sometimes with vehicles serving institutional investors, can be negotiated when investors are able to contribute relatively large investment sums. Concessions regarding management fees can often be based on the size of the investment and are sometimes realisable depending on the stage of the life cycle of the fund or the current situation on the real estate and capital markets.
The first investors in a fund can often negotiate lower fees, sometimes as compensation to agree to participation in blind pools or less diversified portfolios. In the current markets, with investor flows uncertain, the management companies are partly persuaded to attract capital through promising a minimum return or reducing management fees, sometimes inreturn for higher performance fees.
It remains difficult for an investor to monitor the management effort and to decide whether the fees charged are justified or not. However, the increased professionalism of investors and advisrs in selecting and benchmarking real estate investments has already begun to tempt investment companies to outline their fee structures and to create tools of alignment of interests between both parties. This is also backed by a study carried out by the European Association for Investors in Non-Listed Real Estate Vehicles (INREV), which documents an increasing number of real estate funds utilising some kind of performance-related fees.
The degree of transparency often does not vary with the country where the fund is domiciled but with the company and its willingness to publish details of the fund. In this sense, management companies should be incentivised by investors to document their effort in more detail. This can entail periodical measures relating to properties identified, properties acquired, joint venture partners selected or lease contracts signed.
A professional analysis of the fee structure also includes the calculation of management fees in relation to the number of partners, investment professionals, employees or properties, for example on an annual basis, as is often the case with private equity real estate funds. These measures can be benchmarked against those of other funds which potentially provides an indication about the cost efficiency.
Finally, not only location, location, location but also transparency, transparency, transparency becomes essential with regard to indirect real estate investments.
Frank Rackensperger is from the real estate division of Feri Wealth Management