Investors are cutting back their manager relationships; to remain in business managers will need either nimbleness and investor focus or breadth of offering and depth of infrastructure, as Christine Senior reports

The past few months have been characterised by a major reshaping of the real estate investment management industry, driven principally by the crisis. As the recovery gathers pace, the impetus for change continues to exert its influence.

A significant trend has been a number of spin-offs from investment banks that have pulled back their involvement in third-party trading, driven both by poor performance and regulatory pressures. Notable among these are Citigroup, which sold its Citi Property Investors platform to Apollo Management, Blackstone's acquisition of Bank of America Merrill Lynch's Asian real estate opportunities fund, and for rather different reasons the buy-out of Lehman's private real estate funds by former employees.

Further moves in this direction are considered likely, with reports that Morgan Stanley is likely to divest itself of its real estate funds, and rumours of Deutsche Bank eventually selling its RREEF property business.

Adam Calman, principal and head of Europe for Townsend Group, says: "In a way the model of banks trading with proprietary capital and trying to offer investment services to third-party capital is probably broken, not least because of regulatory pressure."

There seems to be no let-up in the strength of the forces that have battered the industry. Tighter regulation, pressure from investors for greater transparency and for more active involvement in the funds they invest in, and a need for greater liquidity in the asset class are all set to contribute further restructuring.

In a paper last year, PwC highlighted the challenges the industry faces - investors demanding lower fees, income sources for many managers drying up as products reach their maturity, and various new regulations raising costs of compliance for real estate managers. All these are conspiring to hit the real estate industry at the same time.

PwC concluded: "The cumulative effect of [these issues] all arriving more or less simultaneously should not be underestimated. If it is, and we see a period of rapid consolidation in the industry, there will clearly be winners and losers. The good news is that .… real estate fund managers have advance warning of what is coming over the next two years and have the opportunity to prepare."

Regulation is certainly a major issue - one that might curtail activities by some institutions. Solvency II will undoubtedly mean that insurance companies will reduce their exposure to direct real estate investment, while Basel III will force banks to reconsider their lending policies, with more focus on lending for less-risky enterprises and on more-liquid assets.

The Dodd-Frank rules in the US, the effects of which are still not totally clear, are likely to curtail banks' proprietary trading activity and prevent them from investing or sponsoring hedge funds or private equity under the Volcker rule, while swaps transactions will be more closely monitored by regulators.

One effect of all this is that it might force some managers to reassess their continued presence within the industry says Ville Raitio, investment manager at ATP Real Estate. "The Dodd-Frank legislation is still a bit uncertain but is likely to lead to some companies re-evaluating whether or not they want to continue in the real estate investment management business. That will drive it further. And for investment banks there will be a question mark over their ability to continue co-investing into their own funds."

Investment banks look certain to be particularly badly hit by regulatory change and forced to pull back to core banking activity. But there could be some winners from this change.

Peter Hobbs, head of group business development at IPD, says: "Those investment banks that are able to continue to participate are set to benefit from reduced competition given those that will be squeezed out of the market." In the meantime, it is the smaller boutiques and larger independent managers such as Aberdeen, Invesco and CBRE Investors that have tended to benefit from spin-offs, he says.

As capital returns to the market, the business model of managers is starting to change. However, a slimmed-down industry is likely to favour those at both ends of the size spectrum.

Hobbs predicts both large and boutique managers should do well in future. "I think both large and boutique managers can benefit, the boutiques because they are very focused," he says. "There is proprietary involvement and they are entrepreneurial, while larger managers have scale. In a world of tighter regulation large managers tend to be better placed to introduce good process and compliance."

Another challenge for the industry, demands for lower fees from investors, could also favour those managers with scale. Jonathan Cantor, a partner in the funds and indirect real estate team at legal firm Nabarro, thinks larger investment managers will be most able to withstand this pressure from investors. "Investors want the lowest fee they can get," he says. "Economies of scale should enable a large organisation to offer reduced fees. A small organisation has the same regulatory burden to bear and might find it more difficult to meet demand for lower fees from investors."

But smaller outfits might be more adept at changing direction should the need arise. And investors do change their taste in funds, so managers need to be adaptable.

"What might be in vogue for a fund at the moment might not be so in a year's time," says Cantor. "Healthcare, student accommodation, waste management are hot now, but that might change. Managers need to be able to adapt to deal with investor preferences. Smaller managers might be able to change their focus quicker because the decision-making process is wrapped up within a few people, though it might be harder to implement."

Capital is likely to flow to strong brands even if there have been legacy issues, says Ian Marcus, chairman of European real estate investment banking at Credit Suisse. Marcus also supports the prediction that the two types of business models that are likely to succeed are the large-scale generalists and the smaller niche specialists.

"I think you will get bifurcation; global players who will play across all geographies, all strategies and all risk spectrums. It will be core to opportunistic strategies, they will invest in debt, equity and securities instruments and they will seek exposure to all major asset classes. If you ask me to pick out names, it will be organisations like Blackstone and LaSalle. At the other end of the spectrum it will be owner-managed vehicles like Europa, Orion, AREA, Resolution, Mountgrange, Brockton, Moorfield, Patron and Benson Elliott that will succeed."

Marcus thinks these smaller companies have the edge because they provide a model that appeals to investors, that of being part of a small group of like-minded investors who can have some influence on the management strategy. These niche players are owner-managed funds that have established a favourable track record, coming out of the crisis with some distinction. "We think the real winners are the owner--managed funds where the management are the GP and institutional investors are really supporting that management," says Marcus.

"They tended to get into this business slightly later by choice, were slightly more -selective as to the deals they did, were not necessarily driven entirely by structured finance and excessive leverage and have good foundations on which to grow businesses going forward."

But this divide means that managers that occupy the middle ground will inevitably lose out. "I see big players getting bigger, niche players emerging," says Marcus. "What you don't want is to get caught in the middle ground."

But looking at it from the investor perspective, Raitio is particularly keen on focused managers, whether small or mid-sized.

"In terms of size we prefer focused and dedicated managers and typically they tend to be smaller or mid size," he says. "That allows managers to be more selective in the execution of the strategies. But at the same time, there are good examples where large funds are necessary for the execution of a particular investment strategy and that's part of the manager's competitive advantage."

But when managers are too focused on one sector or strategy, that might entail risks. "It cuts both ways in that if you are very focused on one single strategy then your business is more reliant on that one single source of income," adds Raitio.

"From what we have seen in the past cycle it might be more difficult for some smaller managers because of that concentration risk. Vice versa, in larger houses with different sources of income, not just real estate investment management, you are more a generalist. Even if that might not be so attractive to some investors, including us, at the same time you might have more staying power in having diverse sources of income and not being reliant on one single fund or strategy."

The market is set to evolve as investors turn their attention to new types of products. Hobbs sees a renewal of the pre-crisis trend for more sophisticated products, using securitisation and derivatives. "There is this long-term trend for ETFs, and derivative trading which is very profound for real estate," says Hobbs. "Through the crisis there has been a renewed call for ‘core' investing focused on the ‘bricks and mortar' of real estate.This attention to underlying assets is critical, but there is a growing need to provide investors different types of return through various forms of structured products. This increased sophistication is going to be a big theme over the coming cycle."

Investor enthusiasm for the UK evident over recent months might well be waning. Douglas Crawshaw, senior investment consultant at Towers Watson, feels that investors might switch their attention to Europe, and perhaps Asia, in future. He would like to see managers providing a wider range of products in Asia.

"I think Asia-Pacific as a whole is interesting, though there are certain sub-regions that feel quite risky," he says. "If more core products were to come through in that region, that will be interesting. At the moment they tend to be more opportunistic products."

Raitio sees an evolution in the scope of global fund strategies. Investors will be seeking more focused mandates. "Types of managers that are likely to be successful are going to be more specialised rather than broad, not just in regions but also by sector. So you could have a strong operator that is good in many different sectors in a narrow market, or the other alternative, a sector specialist who would be strong in that particular sector in a wider geographic area."

This new model is likely to make investors far more selective than they have been. That selectiveness will inevitably mean some managers fall by the wayside. "For most investors there will be a massive reduction in the number of funds they support," says Marcus. "They will place bigger bets where they are more in control of their own destiny with management teams that have delivered and been transparent throughout this difficult time. It's a good time for investors as long as they are not too hamstrung by legacy issues of previous investments."

Cantor agrees that for investors a reduction in the number of managers is on the cards, driven, in part, by the need to cut costs. "As investors have had to cut back on staff they can't have 30 different relationships. They will form a strategic relationship with a small pool of fund managers and invest through them. As a consequence the number of fund managers that need to exist will decrease. That will drive consolidation."

Any consolidation in the industry will effectively reduce choice of managers for investors but Crawshaw does not see this as too detrimental for his clients. What he does have concerns about is the initial phase of the merger when two organisations face major upheaval.

"I tend to take a cautious view of corporate activity certainly to begin with," Crawshaw says. "Merging two companies, two styles, two cultures, sets of procedures, two IT systems, that takes time to bed down. Staff may have to be made redundant, and the company has to choose the right people. One gets nervous. As with any big change, it can be for the better. But I don't think it will affect choice. Out of the universe we are only interested in the top few in each country, region or sector."