Incentive fees can be in investors' interests, but problems arise when style drift creeps into a portfolio. Mahdi Mokrane explains

It would be understandable if some European institutional investors nursing heavy losses on their non-listed real estate funds portfolios after the sharp downturn of the past two years were wondering exactly why they are paying their investment management fees. But in fact most investors are more concerned with keeping the show on the road and ensuring that their portfolios are professionally managed throughout the market turnaround.

Investors who have seen losses in the value of their assets over the past two years believe these are largely linked to yield shift, rather than excessive leasing risk, so they are not usually mad at their managers. Of course there are managers who have crept up the risk curve to extract value from the yield shift and have had recourse to excessive leverage, and some of these late-point-in-the-cycle newcomers are now jumping ship given that their target outperformance fees are ‘out-of-the-money'.

The number of so-called ‘successor mandates' in Europe, where investment managers take over ‘broken portfolios' from other general partners, has, however, been very limited in comparison to the US where billions of dollars in real estate assets have changed managers as companies have thrown in the towel. We expect these portfolios to start being shaken loose from the books of banks and others towards the end of this year.

It is perhaps surprising that more renegotiations over fee levels linked to performance didn't come during the boom period, when many managers could be seen as simply surfing on the wave of liquidity, the famed ‘wall of money', rather than really adding value.
Compared with the market slump in the early 1990s, (which was largely triggered by over-development), when investors did put the spotlight of blame on managers, this time around the downturn is clearly linked to global external factors and the bursting of the credit bubble.

Because real estate investment is essentially a cash flow business it is now vital to retain the specialised skills of the teams managing the assets and the infrastructure of the platforms in which they operate, by ensuring interests are aligned on both sides, particularly in the area of fees.

Quality should be paid for and if the delegated manager has outperformed, then they should participate in a share of the excess profits, so that managers keep their core talent in the investment, portfolio, research, and management teams. Incentive fees are then in the client's best interest. The problems come when interests aren't properly aligned and you get style drift, with some managers taking on more risk than they should in a portfolio.

The key to containing ‘style drift' lies in establishing clear hurdle targets or performance benchmarks, but this has proved to be a challenge for the relatively young European non-listed real estate funds industry, which has only been in existence as a recognisable investment asset class for 10-12 years. In one of the European Association for Investors in Non-listed Real Estate Vehicles' (INREV) earliest annual conferences, the hot topic of debate was the use of Total Expense Ratios (TERs) in non-listed real estate funds. TERs are standard measures of costs in equities and bond funds.

INREV also pushed for the introduction of standard definitions for the three broad real estate investment styles of core, value-added, and opportunistic; they were defined at that time in terms of progressively higher target returns and use of leverage, as well as overall fee levels, not only performance fees.

Subsequently, the association identified style drift in its funds database and decided to develop a broader measure of risks in a portfolio to be able to more accurately classify vehicles. INREV commissioned research which identified a bundle of six key risk factors, including development exposure, income distribution as a percentage of total return, leverage, country exposure, sector exposure, and diversification. Another issue which has challenged the industry in determining fund performance - and so the relative alignment of fees - has been the benchmarking of investment returns.

Absolute return hurdles are the norm for opportunistic and value-added vehicles, mainly because of small sample sizes, particularly when you take into account the difficulty of grouping together funds of different vintages, which may also have very different sources of returns. However, the relative benchmarking of core funds is becoming more robust thanks to the work of INREV and the London-based Investment Property Databank (IPD).

Institutional investors and investment managers have long used IPD indices for the benchmarking of their national direct property portfolios, but the development of the IPD pan-European Property Index is now allowing the performance of pan-European core funds to be compared with the underlying markets for the first time.

AEW Europe is developing a pan-European core fund, which has not been launched yet, but will be benchmarked against the IPD European Index, with some difference in weightings.

We think investors will like managers who can genuinely deliver a transparent outperforming proxy for pan-European core real estate, with a management fee to support the asset management infrastructure and a performance fee linked to how we perform against the benchmark.

Ultimately, it is the team and the track record that count. The investment managers that come through this crisis intact will certainly have an excellent track record for investors to consider.

Mahdi Mokrane is head of research and strategy at AEW Europe