Times have changed in real estate and INREV's first style framework needs an overhaul. The association held a workshop to consult with its members, as Andrea Carpenter reports
The Styles Framework was one of INREV's first initiatives following the association's inception in 2003. Fund managers and investors had already started to use broad classifications of funds by style that were familiar in real estate industry practice, but no one in the European non-listed property funds industry had yet attempted to put a framework around these categories. It was made a first priority as the classification used by different fund managers and investors often differed substantially.
The INREV Styles Framework produced in 2004 gave a definition to these classifications. Now almost four years on it has become clear that the concept needs revising to take account of the evolution of the property investment market and make the model robust for changing market factors.
The INREV styles framework revision is part of a major piece of research being undertaken for INREV by Cass Business School, City University, London. The aim of this research is to provide a set of definitions for style which are workable, robust and enduring. The first consultation with members on the topic took place at a workshop last November.
The existing styles framework defined classifications for three types of styles - core, value-added and opportunity funds - by combining the funds' target IRR at a fund level and the target level of leverage. The definition produced was adopted by the non-listed funds industry.
However, over the years it has become apparent that the model is not robust enough for changing market circumstances. The definitions were introduced when debt was cheap relative to real estate yields and a recovery in the European economies was predicted. The industry is now living through very different times; the cost of debt has risen and yields have fallen. The resulting impact of debt on performance is expected to be less marked, calling into question whether gearing is one of the correct measures of risk.
The issues discussed at the workshop included: what the limitations of the existing framework were, whether IRR and gearing were the right proxies for style classification and what other factors should be taken into consideration, especially related to the measurement of risk.
In INREV's September quarterly report, Russell Chaplin, head of global real estate research-Europe at UBS Global Asset Management, outlined how the factors used in the current styles framework had changed over the years. For IRR, the year-on-year variation in each style remained relatively stable but the behaviour of value-added funds changed over the time period from moving towards the IRRs of opportunity funds compared with core funds in the later years.
The analysis on gearing showed that in 2006, the gap between the average leverage employed by value-added funds and core funds was just under 500 basis points. This initial analysis was useful in raising questions as to whether IRR and gearing should be the right or only factors considered in the styles classification and whether the differential between styles was meaningful in its present state.
These opinions were mirrored in the workshop, as was the view that while the current framework was beneficial for its simplicity, in general, it does not properly reflect property risk. Many attendees felt that a number of property risk factors which were not yet considered should be included in any risk analysis. Many of these related to diversification, such as the number of countries or sectors invested in and also extended to the number and type of tenants.
In addition, there were factors such as development risk, regulatory risk and financial risks such as hedging and debt as well as factors more difficult to quantify, such as the manager skill set. The split of income and capital growth from returns was also discussed.
It was felt that three styles remained the optimum number for any framework. However, there was discussion of a core plus style, which some in the industry do adopt as it was felt there was more variation of style within the core/value-added category, which could be better defined.
Underneath the simplicity of these three main styles it was felt that there was likely to be a much more detailed analysis of several other risk factors. It would be useful to have flexibility in terms of the weighting for different risk factors depending on the investor/fund manager's own needs.
One solution was a metric with a scoring system which could provide a simple approach but could also accommodate investors and fund managers who have their own view on risk factors and could adjust the weightings.
The purpose of the styles definition was also discussed, with many members feeling it was vital for benchmarking. INREV is planning to produce a first sub-index on style for the 2007 Index release to be launched in April 2008.
There was also the question of who should do the classification. Currently, while there is a styles framework in place, the INREV Vehicles Database, which comprises information on 480 non-listed vehicles, adopts the managers' self classification. Many were of the opinion that once the right definitions are in place then the correct information should be gathered to allow INREV to do the classification, especially if these definitions were to be used for benchmarking purposes.
The next stages of the styles framework research are now being undertaken. One point that came out of the workshop is that many fund managers and investors already use their own internal definitions for style classification. INREV is currently collecting these internal models from members which will form a valuable part of the INREV's styles framework revision.
In 2008, the research team from Cass Business School, comprising Tony Key and Stephen Lee, will be conducting a series of interviews with
investors and fund managers to learn more about existing market practice and to understand which risk factors are most important to be included in the model.
Cass will also refer to international property style models and models for other asset classes. A consultation white paper will be released at the INREV annual conference in Istanbul in April in order for the INREV membership and the wider industry to comment on the proposed framework.
Andrea Carpenter is director of research and market information at INREV