Alignment, accountability and leverage are among the issues that the non-listed funds industry must address to ensure that it moves forward and attains its true potential, as Lonneke Löwik reports

During the rapid growth of the non-listed real estate funds sector from the turn of the millennium to 2007, the structure of the industry, the fund model and relationships between actors in the industry developed quickly.

Investors realised that non-listed real estate investment vehicles are an important way to indirectly invest in European real estate that offer some of the advantages of direct investment, such as diversification and a hedge against inflation, without some of direct real estate's perceived disadvantages, such as high entry costs, and the need to hire a team of expert property managers familiar with local markets and conditions. They also realised that non-listed funds are relatively less volatile than some other indirect real estate investments, such as listed real estate funds.

Nevertheless, non-listed real estate funds have some limitations, including often limited transparency and liquidity, and high costs. Many of these issues started to be addressed by the industry through the adoption of best-practice standards and the development of the INREV Index and Vehicles Database, and non-listed real estate funds rapidly became a widely recognised investment strategy that attracted an increasing percentage of institutional investment.

Market downturn
The market turmoil that began in 2007 significantly affected non-listed real funds along with all other financial sectors. Declining property values triggered major debt issues in funds and there was a lack of available capital and debt financing. A lack of confidence in the market resulted in a freezing-up of the resale market, leading to a lack of comparables on which to base valuations that had a major negative impact on the sector.

At the same time, the decline in overall economic activity led many tenants to downsize or ask for rent reductions, which reduced the income stream of some real estate assets, while re-letting was often difficult or only possible at deeply discounted lease rates.

By late 2009, real estate markets in Europe had begun to stabilise. Along with an improvement in overall economic activity, liquidity, availability of capital and debt financing, and sale and leasing transactions all started gradually reappearing in European real estate markets at modest levels. But the new market cycle is seeing a non-listed real estate funds sector changed in some fundamental ways as a result of revised investor preferences and lessons learned from the downturn. Along with investors and fund managers, INREV, the European Association of Investors in Non-Listed Real Estate Vehicles, has been closely examining what impact the financial crisis has had on non-listed property funds as the market moves forward.

The argument for non-listed property funds
Before the downturn in real estate markets, investors commonly cited a number of arguments both for and against investing in non-listed real estate funds. The most commonly cited reasons to invest in non-listed were economies of scale, enhanced performance, access to expert management, access to new markets and sectors, and diversification benefits. Reasons cited not to invest in non-listed were limited transparency and liquidity, product suitability and associated costs; but these factors are not limited to non-listed and apply in varying degrees to real estate as an asset class.

During the financial crisis and in the recovery, the primary reasons cited for investing in non-listed have remained robust but have changed somewhat in relative importance. Two of the top three reasons, access to expert management and multi-sector diversification benefits, remain important, although international diversification has dropped in importance as investors lower their risk appetite and refocus more on domestic markets.

A recent comparison of unleveraged direct and indirect real estate performance suggests that non-listed real estate vehicles performed no worse than other real estate investments. During the financial crisis, the nearly simultaneously decline of almost all real estate sectors and regions eroded some diversification benefits in the short term.
However, in the medium and long term, the lower volatility of core multi-country funds and the greater stability of their returns seen in an analysis of the INREV index confirm that diversification benefits remain an important advantage of investing in non-listed real estate vehicles.

Weaknesses in non-listed property fund structures revealed in the downturn
The downturn nevertheless exposed weaknesses in the established non-listed fund model. Since then, a great deal of consideration has been given to the perceived disadvantages of investing in non-listed funds and how fund structures can be adjusted to address them. The asymmetric risk of fund structures, with fund managers having little real downside risk if they do not meaningfully co-invest, has become an area of special focus. In addition, management fees that exceed the underlying costs and increasing layers of fees, such as introductory fees, acquisition fees, and debt arrangement fees, have come under scrutiny.

Fees based on gross asset value (GAV) have been widely used and effectively incentivise fund managers to use leverage to increase the fund capital base. And, before the financial crisis, in the absence of explicit debt limits, leverage sometimes exceeded otherwise sound levels. Many fund managers and investors have also been driven by the pursuit of ever-higher returns and outperformance, along with increased levels of diversification, which caused them to take on more risk and proved to be an unsound policy in the downturn.

As a result, there was too little alignment of interest between fund managers and investors in some non-listed real estate funds. In some circumstances, the lack of a clear separation between investment management and asset management functions gave rise to conflicts of interest in which managers earned more fees from arranging and securitising bundles of debt than from the management of the fund itself.

The open-ended non-listed real estate fund model was previously thought by many to solve liquidity issues related to real estate, in particular, concerns with the indivisibility of interest associated with direct investing. The emergence of a secondary trading market suggested the ability to trade units on demand and, in this sense, non-listed real estate funds were perceived to have a lower liquidity risk than direct real estate investments. However, issues of valuation and pricing, particularly in inactive markets during the crisis, illustrated that real estate remains a relatively illiquid asset regardless of the manner in which it is held.

In the aftermath of the downturn, the poor performance of some funds, especially many launched late in the up cycle, also caused many investors to question whether they would have limited losses if they had had more control. While non-listed real estate remains important for many investors, some large investors are now starting to reconsider direct real estate, separate account investments and joint ventures to regain some of that control even though the costs associated with establishing a platform to manage such investing are significant.

Reaffirming the role of non-listed property funds
While access to expert management has actually increased in importance as a reason to invest in non-listed real estate since the crisis, the perception of the ease of such investments has declined. This reflects the increased level of due diligence currently being undertaken by some investors into underlying real estate assets, as well as the quality of fund vehicles, their managers and co-investors. Alignment of interest has also sharply increased in importance, reflecting the significance of this issue for the industry. The availability of suitable products as a reason to invest has remained stable, while the importance of other investors has sharply increased although it remains a lower priority to investors in general than several other issues.

Many investors acknowledge that at the height of the boom they failed to adequately provide for the accountability of fund managers in fund agreements, especially with regard to detailing investment strategies and reporting requirements. In extreme cases, investors signed on to agreements that alienated basic investor rights, such as access to regular fund information including value and debt structures. As a result, investors are now keen to redress this balance and retain more control, often through better reporting, going forward.

Whether investors are seeking to assert their discretion in managing real estate vehicles appears to be an area of misunderstanding between fund managers and investors, with many fund managers assuming that greater investor control over funds is synonymous with non-discretionary mandates. However, hardly any investors in a recent INREV survey seek discretion over acquisitions or involvement in the day-to-day management of the funds. Instead, they argue that they simply want to adopt best practice already established in many existing funds that have strong corporate governance and risk control policies. In fact, for many fund managers this may represent no change, as investors focus on creating fund structures that best protect their investments.

As the popularity of investing in non-listed real estate vehicles accelerated from 2003 onward, fund managers introduced increasing layers of fees. Many investors and fund managers currently envision a move toward more standardisation and simplification of fee structures, in tandem with a move toward more relevance of fee structures to investment strategies coupled with fund manager accountability.

Alignment of interest
Most investors and fund managers now agree that co-investment leads to greater alignment of the parties, which should come from the team involved and not from the organisation or sponsor. The level of investment itself is generally considered not as important as how meaningful it is to the individual. Small fund managers often tend to have a higher degree of personal co-investment in their platforms, while in the largest platforms, because it can be difficult to distinguish between organisational and organisation-sponsored co-investment, there is now frequently more emphasis on key man clauses, remuneration policies and the role of investment committees to secure alignment of interest.

Continuity of key personnel involved in the management of the fund and the execution of its strategy is also becoming more important for investors and fund managers. In a market that is competitive over its skilled labour force, assuring longevity is difficult. Within smaller platforms, the level of co-investment in the fund and equity in the business are increasingly used to encourage stability of the fund management team. In addition, investors may require key man provisions, although they are generally more important to medium and large fund manager platforms where co-investment is often less personally committed.

In funds with a long life, there has been greater emphasis on securing the key role, rather than a key person, as a means of ensuring the dedication of the fund management team, thereby retaining the asset and fund history. Investors are also keen to ensure that the acquisition and asset management teams are retained and stay focused. To this end, investors are more frequently attempting to influence the distribution of deferred carry and to ensure that remuneration policies promote collegiality, increasingly preferring fund and organisational pools to allocate rewards as a means of ensuring the broader platform is incentivised to take account of fund performance.

Investing with similar investors
Different types of investors and their impact on investor relationships have arguably led to the greatest strain within the fund model. As turmoil in the financial markets spilled over to real estate markets and private vehicles, it rapidly became evident that investors do not all have the same objectives, level of sophistication, and cultural backgrounds. As a result, investors are currently exercising much greater caution regarding the types of investor they are prepared to invest with and under which circumstances.

As a result of perceived mismatches between investors in some funds, institutional investors are now increasingly focusing on closed-end funds with a limited number of similar institutional investors, generally not exceeding ten. This development has a number of implications as the size of funds may decline due to a smaller number of investors, there may be a greater number of funds, and, with a shift back to closed-ended funds, the liquidity and transparency of the non-listed real estate funds market may be reduced.

Leverage and debt strategy
The explosion in debt markets and its multiplier effect on the weight of capital targeting real estate in the boom had major implications for the market during the downturn. Post-crisis, investors have focused on changing the fee basis to remove the incentives to use leverage, while the experience of loan to value (LTV) covenant breaches, resultant capital calls and negative returns from highly leveraged assets with limited income cover has resulted in many investors rejecting leverage. Presently, low interest rates suggest that a prudent use of leverage is both rational and beneficial, especially in relation to core assets with strong income cover. Therefore, some investors are developing debt strategies as a means of controlling risk while maximising risk-adjusted returns that are based on linkage, sourcing and cross-collateralisation.

Many investors and fund managers now realise that a fund's debt strategy should be clear about the aggregate level of debt permissible at the fund level and for any individual asset. Although it will vary across investment styles, the level of debt should be related to income cover and, to be prudent, loan-to-value ratios should make reference to fair value, representing a long-term rolling average value, rather than a spot price.

Alignment of interest
Underlying the downturn in real estate values is an economic and, in turn, real estate cycle. As the markets accelerated, investors pushed fund managers to generate ever higher returns, encouraging higher leverage without considering incremental risk. In response, fund managers and investors are now increasingly focused on developing risk metrics that consider the fund management risk, the portfolio risk and risk associated with individual assets.

Lonneke Löwik is director, research and market information at INREV, the European Association of Investors in Non-Listed Real Estate Vehicles