In the pursuit of a more liquid market there are calls for a more organised secondary market says a new INREV survey, presented here by Sheta Patel
In today's market more European real estate investors are looking for liquidity. This could be to proactively make strategic changes to existing portfolios or, more reactively, to re-balance across the asset classes if allocations to real estate are overweight. Either way, it leaves real estate investors facing the task of exiting what has historically been the most illiquid asset class.
Therefore, it may be surprising to know that the majority of European non-listed real estate funds are structured to allow investors to exit their investments. The INREV Liquidity Provisions study shows that 93% by gross asset value (or 89% by number) of funds offer some kind of liquidity option, either through redemptions or trades (figure 1).
It should therefore be the case that if willing sellers meet a liquid product a working market can develop. However, the market conditions that are driving the current need for liquidity in the first place are now restricting that liquidity being exercised. The development of a secondary trading market is being hindered by issues of perception and pricing but there is a possibility that the increased focus on trading at this time could result in a more efficient market in the future.
Liquidity for non-listed property funds comes in two forms. Redemption is where the selling of shares changes the size of the fund's capital base while trading sees the capital base remain constant and shares are traded with existing or new investors.
The availability of liquidity in the non-listed property funds market is often characterised by the return/risk profile or style of the fund. The INREV Liquidity report shows that value added funds offer the most liquidity with 94% offering exit options while 84% of core funds offer investors similar opportunities to exit. Opportunity funds were found to be the style offering the least liquidity with only 3% offering exit options.
These findings are not surprising when you consider that core funds' underlying assets should be easier to dispose off as there is less risk associated with this type of fund style. Also opportunity funds are associated with a shorter life span which calls for less structural liquidity from investors.
When it came to analysing liquidity provisions by structure, there are interesting overlaps. In the study all open-ended funds offer liquidity provisions but also a high number of closed-ended funds, as shown in figure 2. In addition, a small number of closed ended funds offer redemptions as well as trades. This is an important finding from the study as closed and open-ended definitions have been important differentiators of liquidity. In general, open-ended funds are seen to offer much higher levels of liquidity than closed ended funds. The findings of the study show that the liquidity being offered to investors is more often determined by individual fund terms than structure.
The study also found that the variety of liquidity provisions over the last 10 years has grown. Figure 3 illustrates that funds launched in 1996 or earlier allow for only two different options to meet investors' demand for liquidity while funds launched since 1999 show the option of trading increasing. This trend also reflects the rise of closed ended funds in Europe.
It is clear from these findings that many funds have the structural liquidity provisions for investors but are these routes of exit actually being exercised? When considering the option to trade, of the 127 funds in the sample, only 22 actually experienced trading. This highlights that although the option of trading is available to investors, in reality it has so far not been used.
One explanation for this could be that investors in this market are often perceived as distressed sellers if they are looking to trade. Investors may not be distressed if they are looking to trade but instead are looking to rebalance portfolios or trade out of funds for alternative investment opportunities. But in this market these investors are being treated the same as those that are distressed. The perception of this can result in different pricing expectations between buyers and sellers, which will then restrict the number of trades that actually occur.
The issue of pricing trades in the market is also an important reason why few trades are occurring at this time. Valuation of assets in this market is challenging due to a lack of transaction evidence. A recent INREV Investor Survey showed that 65% of investors and 75% of fund of funds managers said that they were not confident that valuations reflected fair value. However, it is these valuations that feed into producing the net asset value for the fund, which is usually the starting point for pricing a trade. Without a reliable starting point for price, fewer trades will happen.
While the higher level of interest from investors may not have resulted in increased trading at this part of the cycle, it is possible that the process of investors exploring the option more may result in increased trading in the future.
Interviews with investors for this study showed that there was an expectation that the number of trades would increase during the coming twelve months. They also saw it as important that a more organised market should develop. Recent times have made investors educate themselves better about the possibilities and practicalities of liquidity options. It may be that when there is a more settled market for pricing, investors may consider the option more regularly. This could lead to the creation of a larger and more organised secondary market.
INREV has undertaken initiatives to support the development of a secondary market. This includes this Liquidity Provisions study as well as the release of the Secondary Market Guidelines in late 2006, which are now incorporated in the integrated INREV Guidelines document. The Guidelines cover rights and obligations of investors and fund managers involved in secondary trades as well as a code of conduct and recommendation on disclosure of information on potential trades.
Shetal Patel, INREV Research Analyst
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