The Crown Estate owns assets in the UK as diverse as wind farms and shorelines, but also manages a sizeable commercial portfolio. Investment director Paul Clark tells Richard Lowe why the industry needsto rethink its blind use of leverage on core assets, and why fund managers must be rewarded for cash profits, not paper ones
Paul Clark, director of investment and asset management at The Crown Estate, was asked to speak about risk management at the IPE Real Estate Investor Forum in Amsterdam earlier this year. As someone overseeing the investment strategy for an organisation with a £7.3bn (€8.6bn) property portfolio, the profits of which go to the UK Treasury, Clark was undoubtedly well placed to provide the audience with some insight on the subject.
But one of the most interesting points raised was rooted in Clark's experiences during his previous professional capacity - that of running the smaller, but by no means modest, real estate portfolio of the Church Commissioners (itself a unique UK institution). During his four years at the institution Clark led the Church's first foray into international indirect investment, committing to a number of funds.
"What I saw from other investors," he said, recalling the widespread rush among many investors to simply gain access to real estate funds prior to the downturn, "was more of an attitude of being capital allocators".
He added: "It was all about getting the money away and not about what happened with the alignment with the managers and other investors, the liquidity or exit routes."
Clark also extended this criticism to the subject of gearing, especially concerning the somewhat lazy assumptions that dictated that funds of a particular style, whether core, core-plus or value-add, should automatically be subject to a standard level of gearing, without considering what the leverage is there for.
"It is beholden on the investors to be really precise about what they want," he said. "When you look at a financial structure for an investment, you need to understand what it is doing for you and why it is worth having that financial structure rather than just accepting that ‘it is this sort of fund, therefore it will look like that'."
Speaking separately to IPE Real Estate, Clark returns to what seems to be a major bugbear for him, observing that over the past few years there has been too much emphasis on leveraging core assets.
"I am not sure gearing should be routinely put into core vehicles, and I think the argument that used to run - ‘it's a core vehicle, therefore it should be 35% geared' - is not helpful when investors are not usually going into the investment for financial engineering purposes," he says.
"Managers should try to give them as close to real estate returns as they can. And if those sorts of vehicles are going to use leverage then they should use it for activity - if they want to develop or refurbish, or maybe they want to acquire additional assets for a particular reason and investors don't want to offer up more equity. Then it is legitimate to use gearing, but to just stuff it in at a certain level, because ‘that's what you do with core real estate funds' I don't think is right".
Equally, Clark argues that there has not been enough emphasis on rewarding managers for cash profits. "Managers have been incentivised really to hold properties," he says. "When you ask, ‘why aren't you taking cash profits,' they say, ‘well, it's a seven-year fund and we're only three years through it'".
The scenario is likely to apply to fund managers that could have sold assets and taken profits for their investors at the peak of the market in 2006 and 2007, but had more of an incentive to continue to manage assets for the full life of a fund. Consequently, he says, the standard fund model - that is, a five-seven-year fund with gearing, total return-based - has been "stress tested to a point where we can see its failings".
What does this mean for The Crown Estate's future investment strategy? The current £5.5bn commercial portfolio is almost entirely comprised of direct holdings (it also owns close to another £2bn of diverse assets such as wind farms, the largest rural investment portfolio in the UK, and 50% of the UK's shoreline and all of its territorial waters); a fraction - approximately £700m - is invested indirectly, such as the stake in the Lend Lease Retail Partnership fund. While there are no plans in the immediate future to embark on a new international indirect investment programme, there is nothing to say the Crown Estate will not follow in the footsteps of the Church Commissioners one day.
In the meantime, Clark's feelings and observations about the real estate fund management industry will have some bearing on the Crown Estate's investment activity.
"We are likely to do less club deals and more joint ventures, so we don't have to pull so much sovereignty," Clark says. He will be targeting "very small partnerships" with two or three partners, rather than five, six or more.
Furthermore, in the short term, the Crown Estate will be targeting core or core-plus opportunities, because, as Clark says, "it is such good value" at the moment.
"You don't need to go to value-add or opportunistic, because you can get some really good returns at current pricing from core assets. So why would you take any more risk? You are being pretty well rewarded at the moment buying prime real estate and for buying direct rather than through indirect vehicles."
Clark's biggest challenge since moving to the Crown Estate has been to reposition its medium- to long-term strategy, such that it can "take advantage of the substantial market correction". All income derived from the estate goes to the UK Treasury and the pressure is certainly on during economic and market downturns to continue to provide returns.
To do this, Clark has been leading a reduction in the Crown Estate's heavy weighting to central London in both its commercial and residential portfolios. The aim is to decrease its central London exposure from 80% to 60% over the next three-five years. Capital that is freed up by this move will be re-invested in retail and industrial assets, as well some additional residential.
"Over the next 12 months or so we will have up to about £200m to put in the market," he says. "We will be aiming to put that into dominant retail and industrial markets, rather than offices, which are still in the wrong part of the cycle for us."