ING Real Estate is battening down the hatches, focusing on core areas of business and looking after existing investments. Richard Lowe speaks to George Jautze about the challenges ahead

If you want a barometer for the global real estate industry, MIPIM is not a bad place to start. The week-long property convention in the south of France visibly contracted this year, both in terms of delegate numbers and outward extravagance, as though in empathy with the wider mood of the sector.

There was still a long line of yachts, but among them a number of omissions, not least the absence of ING Real Estate's eye-catching three-masted schooner. The decision to forgo the vessel was probably apt, in line with the company's current strategy of concentrating on core areas of its business.

It should be remembered that the real estate business's parent company, ING Group, posted a net loss of €729m for 2008 and since last autumn has received a €10bn capital injection from the Dutch treasury. The group is planning to form a single global investment management business, while last month ING Real Estate Investment Management announced that its CEO, Robert Houston, would be stepping down in the summer.

In addition to overseeing the reorganisation of ING Real Estate and assuming the role left by Houston in August, George Jautze, CEO of ING Real Estate, has the task of overseeing the fortunes of Europe's biggest property asset manager.

"We have set a few goals for the company that deviates from the past," says Jautze, speaking in a sunny but breezy Cannes. "The past was building for growth and we [became] larger and larger, and there was a market there and investors really did like the products we put on the market.

"But that is not the strategy any more. The strategy now is to take care of the existing products that we have for our clients and to be as proactive as possible on rearranging debt positions with the banks. That is very important - to be very clear with all our investors on what is happening. That is absolutely the main focus of everybody in the company."

Jautze does not despair about the current predicament, but he is realistic about what lies ahead for the vast majority of real estate investors. "This year will be a struggle for everyone in the real estate profession," he says. "But, of course, not only in the real estate profession - every part of the economy will have the same issues."

If MIPIM acts as a barometer for the property industry, then investors should not necessarily see its deflated numbers as a sign that real estate markets have reached the bottom, and indeed Jautze is not presuming there will be a bounce-back after this year's somewhat muted event.

"This MIPIM is not the end of a period, but it is somewhere in the middle," he says. "So let's see what the MIPIM next year will bring. But for this year it will be a struggle on getting the right valuations on board, getting the right agreements with the banks on board, to get the loan-to-values right again and then continue."

ING Real Estate's various investment products are predominately core - with the exception of some of its Asia-focused funds - and the average gearing level across funds is near to the 50% mark. Jautze says that investors such as ING Real Estate, which have not used high levels of leverage, will be in a better position than those that have.

He describes the latter as investors that "use the fundamentals of real estate as part of a financial play", rather than the traditional approach of identifying real estate as a long-term investment positioned, in terms of risk and return levels, somewhere between equities and bonds, and a hedge against inflation. "I think that will come back over time," he says.

Today it is simply not possible to obtain leverage at 90% or above. But are investors ever going to want to finance their investments so aggressively again, given the experiences of the last 18 months and the future distress that is expected to arise?

"I think it will take a long time before people step back into that one again," Jautze says. "It also depends on the price of capital going forward and the price of debt going forward. I would think with this experience people would not invest in the same way again, with the leverage on top, etcetera.

"But on the other hand, we are all humans. After the internet bubble in 2000-01, everyone said people would be very careful with their investments in equity. They were not, at the end of the day. There is a collective memory that is always very short. But I would say that by looking at everything that is going around, it has a very deep impact on a lot of players in the market and will not be forgotten very soon."

Jautze's real estate career started in 1973, but he admits to never experiencing anything that "even looks like what is happening now".

He adds: "I have seen a lot of recessions in real estate. They were almost always caused by a combination of very high interest rates and extreme overbuilding by developers. That is not the case today: we do not have high interest rates; we do not have a huge overbuilding by developers. Okay, we saw some of it with residential in the US and some of it with residential in Spain, but overall you do not see cranes everywhere in New York or in Paris."

A deteriorating global economic picture may spell worsening conditions for the future, but for the moment property fundamentals are still strong, Jautze says.

"When you look at the underlying real estate, in general it is doing rather well," he says. "Most of real estate worldwide is still well occupied, [tenants] still pay their rents, cash in companies is there. Of course, that will be under pressure as the recession goes on and on. But the biggest part of it is the capitalisation, the way the finance is arranged in equity and debt of the banks."

Despite all the pain and distress forecast for this year and next, there is perhaps just as much talk from the fund management industry about the emergence of an unprecedented investment opportunity in the coming months and years. Capitalising on distressed assets, entering into the debt space and buying at the bottom of the cycle are the sorts of themes being talked up.

However, Jautze is cautious about re-entering the market today. "Nobody rings the bell when you are at the bottom of the market," he says wryly. "Every investor has to do their own assessment on whether they think it is already bottoming out. Every investor will make their own calculation on where they think they will get enough risk premium on top of the risk-free rate to step in again. I don't see investors at this moment behaving like that."

Jautze is particularly cynical about the distressed debt opportunity currently being pushed by a number of investment managers. He does not question the concept per se, but rather the expertise and resources required to implement it successfully.

"When I talk to fee managers worldwide who are doing the investments on behalf of their clients, I hear a lot of sound bites on distressed debt. They think that is the future," he says. "Of course, that is easier said than done. This is a real issue for people who have the knowledge of banking. You do not just step into distressed debt. You have to really know what is going on there."

There is also the issue that debt investments might not be seen by pension funds as pure real estate assets or may fall outside their strict asset allocations.

"Why do pension funds invest in real estate," Jautze asks. "The lesson I learned over many, many years was that it was trading somewhere in between equities and bonds, it was a good hedge against inflation and it was a sort of safe haven when things economically would go wrong."

He believes this traditional role of real estate for institutional investors has been threatened by a growing trend in recent years towards aggressively financed transactions. "What you see is that the models of diversification are not working any more," he says. "But I am sure that when the deleveraging is done - which, by the way, is complicated - then the models should work again."

Certainly, the investment mantra of ‘diversification, diversification, diversification' has suffered in what has been a downturn so comprehensive that nearly all markets and asset classes have been negatively affected. However, Jautze is confident the principles of diversification will sustain themselves in the long term, as will the appeal of real estate to institutions.

"I am reassured by discussions I have with investors," he says. "I have not met any investor who is looking at real estate in the future as a sort of no-go area. They all say, 100% of them, ‘we will stay in real estate, but we want to do it differently than we did in the past'."

And how will they do differently? Well, this depends on the individual investor. "Every investor will come to their own conclusion," Jautze says.

The issues on the table include gearing levels and leverage, which Jautze expects will stay at lower levels compared with recent trends, because investors will demand it.
There will also be a reassessment of the split between money allocated to the listed and unlisted sectors. "They will be looking for a new balance in this," Jautze says.

A third issue, of course, is liquidity, which Jautze believes needs to be addressed by the industry, or at least investors need to accept that they cannot rely on it being available in real estate investments.

"In the present market every liquidity instrument is killed," he says. "Some of the funds that had real liquidity - like the German open-ended funds - had to close." He points out that open-ended funds suffered unmanageable levels of redemption requests not because investors were unhappy with the funds themselves and their underlying assets, nor with the real estate asset class as a whole, but because they simply were one of the few investment structures offering liquidity.

The closed-ended funds sector is also undergoing a reassessment of its liquidity provisions, following a growing number of limited partners coming under pressure to exit such investments. This has prompted a great deal of talk about the emergence of a more active secondary market. The European Association for Investors in Non-listed Real Estate Vehicles (INREV) even held a seminar at Mipim on the topic, while also revealing results from its Liquidity Provisions Study, including the revelation that €1.1bn secondary trades had taken place over the past 12 months.

ING Real Estate offers fund investors the ability to trade out of their closed-ended funds, although this provision is designed to work in a normal market where such exits are rare occurrences.

"The way we do it ourselves in some of the funds is we say: ‘Okay, there is liquidity; investors are allowed to show their interest in divesting out of the fund, because they want to reassess their portfolio or whatever is going on'," Jautze explains.

When an investor does look to exit, ING Real Estate will look at offering the stake in the fund to existing investors and then to potential bidders in the market. "We had a very good experience with that with some of the Dutch funds we have. But again, it works under normal market circumstances, but not in a market where everybody is simply looking for liquidity wherever it comes," Jautze says.

Finally, alignment of interest will be an aspect investors will be focusing on as we move through the downturn - are fund managers properly aligned through both the good times and the bad? ING Real Estate is known for its significant co-investments in funds at a company level, and in recent years it has looked to ensure fund management teams are properly incentivised by asking them to co-invest at an individual level.

When ING Real Estate launched its funds business over 10 years ago, it typically took stakes of 50% or more in its products to ensure it was in control. "Of course, that changed over time; the market acknowledged our knowledge of fund management, so the co-investment levels went down very quickly to 20% in some funds," Jautze says.

"Going forward, these co-investment levels can be much lower. Investors do not demand those kind of large co-investments any more from the sponsor company, so that will come down to 5% or even lower.

"Not so much in the past, but today investors really want to have an alignment from the team that is really running the fund, to ensure there is also a personal benefit to the team when the fund is going well."

As Jautze says, "co-investment means the upside and downside, not only the upside. That is a balancing act, which I think we have worked out now."