The change in market conditions has seen a shift from sellers' to buyers' market; and as before investors should actively target the best opportunities. Richard Lowe reports
There seems to be an emerging consensus that, despite the recent downturn and uncertainty affecting real estate markets, most institutional investors are not planning to exit the asset class, and in many cases are actually seeking to increase their exposure. This is heartening news for the real estate industry, but equally means that pension fund investors face significant challenges going forward.
One of the most common drivers of the continuing appetite for real estate is that a pension fund is still in the process of achieving its target allocation. This is the case for the €4.5bn Austrian investor VBV Pensionskasse, as revealed in the latest investor forum (see page 15).
"With real estate we have the general problem of how are investors to evaluate prospective ideas," says Günther Schiendl, CIO and member of the board at VBV. The one thing that can be observed with so many real estate investors is that they are always behind their target allocation. They wish to have 10% invested in real estate, but at the end of the year they find out that typically it has been just 5%."
The issue can be in part due to the growth in the overall capital value of the pension fund, but it is also invariably dependent on the length of time it takes to commit capital to various investments. Then there is the matter of finding suitable products and vehicles to access appropriate investment opportunities given the pension fund's due diligence requirements and investment objectives.
Schiendl says that the biggest challenge for him is sourcing "the right products".
Unfortunately, this task is likely to be even more challenging today than in recent years. The benign investment environment of recent years characterised by unbroken blanket capital appreciation has vanished. Today's investors need to be more selective with their investments.
Investors will naturally always want to be invested with the best fund managers available, but seeking the top performers becomes even more of a worthwhile endeavour in troubled markets. The problem is it can be difficult to assess which managers are likely to perform well in times of downturn and dislocation when their track records have to be judged mostly, if not entirely, against a backdrop of unbroken growth.
"A lot of managers show stellar returns," says Patrick Kanters, managing director, global real estate, at ABP Investments. "Of course, a very large proportion can be due to the yield compression. It is quite a challenge to understand how they created value on top of that yield compression."
Greg Wright, senior consultant at Mercer, advises pension funds in the UK- along with some continental European and Australian institutions - on gaining real estate exposure, most commonly through either open-ended diversified funds or through closed-ended funds of funds.
In terms of the former route, Wright admits there are "some established funds with quite long waiting lists that are difficult to get into".
He says: "We know the choice of managers we would really like is constrained in some cases by some relatively long waiting lists. But we find that we can get round it. There are plenty of other managers and we are perfectly comfortable with them and clients are able to get invested."
Nick Duff, head of property at Hewitt Associates, also advises pension funds on gaining access, invariably via multi-manager funds or funds of funds. There are other clients that prefer to employ the consultancy firm's expertise to select a number of single property funds.
In terms of the processes to evaluate those managers, Duff, who has a background in fund management himself, notes: "I've been through downturns before and you know what to look for. What I like to see is managers that have performed well in difficult markets and really do have a local expertise or, alternatively, have access to local expertise to the markets they are targeting - where they can source the deals, where they are very strong at asset management, very good at tax planning, etc."
Duff hypothesises that he would consider a fund manager's investment proposals even if they targeted a particular market or sector where there were perceptions of underlying problems - for example, potential oversupply issues or a high risk of yields rising and rents are falling.
"If that manager has a clear way forward in terms of what he wants to buy and what the opportunity is, and he can clearly communicate that and prove he has done it in other funds he's launched, I would potentially take a view on that," he says.
"A good fund manager will always raise capital in a weakening market, because a good fund manager can exploit opportunities in the market even when yields are rising."
And it is precisely this ability to raise capital in any market environment that can make top fund managers inaccessible to many investors. However, Duff does offer a note of optimism for investors who in the past might have missed out on opportunities in favour of investors with greater capital or investors that had already invested with a manager in the past. It seems that today the tables may have turned somewhat so that fund managers do not necessarily wield the most power when it comes to securing capital for their fund launches.
"It is an interesting time," says Duff. "Whereas in the middle part of last year managers were finding themselves significantly oversubscribed, you will find now that for a lot of funds coming to market they are chasing capital. They do not have the luxury any more of having the massive queue of investors waiting to invest the money into their product.
"I think we are seeing a slight correction in terms of who controls the terms of the deal at the moment. It has switched a bit more to the investor away from the fund manager."
Frank Rackensperger from the real estate division at FERI Wealth Management advises German pension funds in gaining access to suitable real estate exposure. He has certainly seen a growth in fund managers "seeking money", particularly those who have been hit by heavy redemptions recently.
"We saw some fund managers asking us if we would like to come and invest as they, of course, needed the money at the time," he says. However, he emphasises the importance of actively searching for and screening new funds, rather than waiting for managers to approach the investors themselves.
Schiendl brings up another important point. If investors are not taking a proactive approach when seeking investment opportunities, they will typically only gain access to "standard managers with standard products" he says.
Rackenperger agrees: "It is important to actively screen and actively search for new funds." In the first instance, investors should determine what regions and sectors they want to invest in, and then acquire an "independently collected" list of potential investment funds.
Another difficulty concerns the short window of opportunity often offered by fund launches, which can place a strain on pension funds' due diligence processes.
Rackensperger says that this has implications for due diligence, but believes there is no black and white situation where investors will always have to compromise due diligence in order to secure investment with the best opportunities.
Rackensperger currently sees "a huge difference" between the various fund managers in terms of their communication with prospective investors.
"Some managers are relatively open in their communication to the investors," he says, whether through informing investors about an investment opportunity in advance or actually pursuing a two-way dialogue with investors to find out the sorts of funds and products they are hoping to see emerge in the market.
"I've just had a letter from one fund manager here that asks, as an investor, to give recommendations or ideas where to invest, what to do. Sometimes there is an open communication, so we have enough time for due diligence," he says. "The best fund managers attract capital in a fast manner, but nevertheless we often have some other possibilities to lengthen the due diligence."
Should pension funds seek to access real estate exposure ideally through open-ended or closed-ended vehicles? The former can offer investors greater accessibility and liquidity, but certainly pension funds often look to gain liquidity from other parts of their investment portfolio, affording them longer investment horizons for their property allocation.
"What we see generally is that pension funds are allocated to closed-end funds," says Rackensperger. "From my point of view, this makes sense, because they are long-term investors and have an investment horizon of five or 10 years, for example. From that point of view, closed-end funds fit into the investment strategy. It might be different for private investors who want to redeem their shares within three years, but - and this is what pension funds have to note - if you have a fund that is liquid you should normally pay a liquidity premium, which means your returns are likely to be lower."
Wright sees an increasing use of closed-ended funds by UK pension funds, with the exception of the diversified funds, which "tend to be more open-ended in nature".
He explains that trustees are not always familiar with closed-ended structures and consequently can sometimes be surprised when they come across them, but they are not generally averse to the reasoning behind them once it is properly explained.
"There have been one or two raised eyebrows from trustees who haven't been used to investing on that basis," Wright says. "But any trustee who has had a private equity investment will be used to it.
"The use of closed-ended vehicles is being made apparent for the first time [for many UK pension funds], even if they have had property investments in the past, because they have not needed to use closed-ended vehicles in the UK. But once you explain how the structure works and that it will be drawdown rather than immediate investment, generally speaking it is very easy to accommodate.
"The idea of staggering investment, which naturally comes through a drawdown process, is actually quite appealing for a lot of trustees at this point in time. I think they are a little bit nervous about picking any one day to put relatively large sums into any of the markets. The natural spreading that results from the drawdown process actually has some comfort attached to it."
Rackensperger says that since pension funds should usually treat real estate as a long-term investment, "with assets matching their liabilities, the liquidity of the investment is not such a great issue".
He adds: "Additionally, the possibility of immediate accessibility is mitigated as an increasing number of real estate investment possibilities is offered on an ongoing basis. If they want to, pension funds can improve their possibilities of accessibility and liquidity if they choose investment vehicles with cash call systems and redemption periods."
Pension funds can make use of semi-open vehicles where, as Rackensperger explains, "investors have the possibility to redeem shares after three or four years without paying any redemption fees which they would have to pay before. That is the middle way between the two."
Sister company FERI Rating & Research has canvassed pension funds and other institutions whether this structure appeals. The general response was that it could play a role where pension funds might require slightly more liquidity for some of their real estate investments.
"But generally," Rackensperger says, "I would say the closed-ended vehicles will stay the most important real estate vehicles for pension funds."