The following report was based on RE-Invest, a summit for institutional investors at this year's MIPIM convention in France
Institutional investors - such as those who manage pension and sovereign funds - essentially channel funds from savers to borrowers who wish to pursue profitable opportunities. They walk a fine line between generating the income their constituents expect and protecting their capital. In order to meet these seemingly conflicting objectives, institutional investors spread funds across a broad range of asset classes, including prime quality, core commercial real estate.
However, commercial real estate presents unique challenges for institutional investors. Property investments are lumpy and often illiquid because transactions typically occur in private markets. Deploying capital in real estate also requires local expertise and experience, which institutional investors cannot efficiently provide internally. For these reasons, the original model of directly holding trophy properties has progressively given way to the real estate fund investment approach. In this approach, institutions entrust the task of allocating funds to properties across the globe to general partners (GPs) who specialise in that activity.
Challenges to the real estate fund management model
The model performed very well during the economic boom that followed the turn of the 21st century. So well, in fact, that investment models requiring less supervision and diligence by institutional investors began to thrive. Epitomising this post-2000 rise in complacency are blind pools. A blind pool is a fund structure in which funds are raised on the sole basis of a broadly defined strategy and prior to defining or committing to specific property targets.
The financial crisis that started with the collapse of Lehman Brothers in September 2008 has put this fund model under unprecedented stress. Capital losses of historic magnitude have prompted large investors to question past practices and demand significant changes in how they interact with partners and fund managers. For the time being, these losses have also fuelled a flight to quality, and real estate yields in core markets have fallen back to pre-crisis levels.
The fund model and the investors that rely on it must now address a number of new pressures. In recognition of these pressures, Reed MIDEM convened 30 key players in the real estate intermediation process at MIPIM, its annual trade show that takes place in Cannes, France. The group invited these key players from around the world to discuss and debate the future of institutional investment in commercial real estate. The resulting event was the Real Estate Institutional Investors Summit, or RE-Invest. RE-Invest addressed the issues large investors care about the most. It gave way to deep insights on current prospects for commercial real estate and also generated suggested improvements to the fund model to help it to survive. The summit participants were organised into five roundtable groups. Each group discussed and developed a specific topic, delving more deeply into the question of the need for a new fund model. This report summarises the resulting proposals and forecasts.
An informal pre-meeting Thought Starter session by IP Real Estate and a survey conducted by KPMG identified the current fund model's most glaring area for improvement: the incentive alignment between investors and managers. Investors are so concerned about incentive issues that joint ventures (JVs) and club deals - just two of the many ways to sidestep delegated investment - are returning to favour. One group of investors and managers at RE-Invest explored the future of these investment partnerships. A second group was tasked with defining the right balance between discretion and investor control; the fund model must strike the right balance in order to face increasingly intense competition from less intermediated approaches. A third group evaluated the future of blind pools, the most extreme form of intermediated institutional investment.
Somewhat surprisingly (given the outcome of the KPMG pre-survey and recent press accounts), these three groups all concluded that the fund model would survive its post-crisis challenges. This forecast includes the highly criticised blind pool approach to investing. However, in order to survive, the model will need to change in substantial ways. Direct representation by investors in these funds will increase, with strict oversight of - if not total control over - changes in strategic goals. However, execution of the agreed upon strategy should remain within the purview of local managers; this is because large investors do not have the local expertise that managers provide. Managers will also be expected to make larger, more meaningful contributions to their projects. The purpose is to make abandoning ship during turbulent times a prohibitively costly option for managers.
Two other groups of thought leaders addressed the prospects for commercial real estate investment in general. A first group identified markets in Europe that continue to have promising investment opportunities despite the current turmoil. A second group debated whether or not the current run on core markets would soon slow down. Both groups concluded that the flight to quality would continue to dominate real estate investment patterns. However, they both expect that a greater share of global flows will begin to trickle to some of the most promising alternative markets. These include the greater periphery of core cities and emerging markets. This phenomenon will reinforce the need for a high degree of local specialisation in management that the fund model makes possible.
Time for a new fund model?
The thought leaders' debate about the future of the real estate fund management model was very diverse. Most of the thought leaders did not view the current situation in black-or-white terms. There was a clear understanding that the industry will never be able to invent a totally new model; rather, it must evolve with the existing approaches within an uncertain economic and political environment. However, the thought leaders see the industry trend moving towards direct and sustainable investment. Investors must determine at which point they should stop direct investment and move up the risk scale towards investing money with funds. The economic crisis has proven that the existing model functions poorly in difficult times. As a result, there is a strong need for greater transparency and due diligence within the industry.
It has been pointed out that the fund model's evolution has progressed from a first generation with direct investment outside the country, slipping into a second generation of club ventures across borders resulting in a third generation of finding local partners. This underscores the importance of access to knowledge and expertise but also transparency and direction. The thought leaders emphasised that the real estate industry has done a poor job of communicating risks. As a result, the real estate value chain is expected to move towards more information, documentation, reporting and regulation. It appears that the future generation will be more fragmented in order to meet the needs of different investors. In this way, investors will ensure higher quality of data and knowledge for their investments.
Topic 1: Perspectives on a new model - a new model only for large investors
The members of the first roundtable shared their thoughts on the future of current types of funds. The traditional model - with limited partners (LPs) playing a limited role in fund management - is unlikely to survive much longer. In fact, a shift to a new model is already underway. As a result of recent financial events, LPs are now able to exert greater control over investment decisions. The past few years have also seen a sharp increase in the use of JV and club deals. However, it appears that the change only applies to the largest investors: these are the ones that can operate on the scale necessary to implement direct investment strategies. A pooled fund model is still required for smaller investors that do not have the resources and geographic expertise to carry out direct investments themselves.
Topic 2: Perspectives on a new model: tightening the existing model - alignment of interest
The thought leaders all agreed that the existing fund model is not entirely broken, but that it does need to be improved. As the new real estate cycle begins, the era of investors granting their fund managers broad discretion is over. Investors are now demanding far more transparent descriptions of the fund's strategy and a clear definition of the working relationship between investors and managers. Investors seek full details on the country and product mix target, a clear description of the investment's timing and exit, as well as specific risk-return goals. While the fund model will continue to exist for a long time, it must be refined to accommodate a new post-crisis reality.
Topic 3: Perspectives on a new model: the new model resembles the old model of direct investment - increasing investor control
This topic's thought leaders unanimously called for a new fund management model in the wake of the recent crisis. Investors at both institutional and retail level are requiring more control and transparency. In many ways, the new model may resemble the old model of direct investment. Investors today are using more club deals and JVs with local partners in order to leverage local market knowledge without relinquishing control. Investors should also focus on markets they know well so as not to depend on a local partner for expertise.
Topic 4: Perspectives on a new model: a combination of existing strategies - need for some modernisation
Generally speaking, the thought leaders for this topic saw a bright future for fund management. While current forms and structures sufficiently meet investors' needs (broadly speaking), they may have to be combined in new, innovative ways. Trust between investors and managers will become increasingly important, and this trend will be reinforced by growing attention to due diligence and increased transparency. Due diligence must include a thorough investigation of a fund's background, including company history, track record and management performance. After the investor has invested capital with the fund manager, it is also crucial that the GP remains fully transparent in terms of strategy, risks, future acquisitions and dispositions. So while the real estate fund management vehicle will continue to appeal to institutional investors and have an important impact on future commercial real estate investment, trust, due diligence and transparency must become key parts of the process.
Topic 5: Perspectives on a new model: moving back from complexity to simplicity
The general outlook at this roundtable was positive and optimistic. At the same time, it was clear that the institutional investors - which made up about half of the roundtable - were deeply affected by the recession. These investors all called for some form of change in the fund management model. They did not, however, call for a complete overhaul. Instead, they emphasised the need to tighten and simplify the current structure.
Much of the discussion centred on LP involvement. The group of investors unanimously sought a number of fund structure transformations. These included better GP communication, transparent and focused investment platforms, and a greater level of LP control and influence.
‘Tightening' is broadly viewed as a method to deal with greater volatility and uncertainty. Having a more defined investment platform should help alleviate concerns associated with excessive GP freedom with respect to actual investment choices. Several LPs present described having felt taken advantage of on a number of occasions. They would find themselves in situations where they were exposed to assets that were not necessarily part of what they thought the fund was contracted to deliver. This put many of them in an uncomfortable situation vis-à-vis their constituents and with a higher risk profile than they had originally sought. While LP investments into these funds are ostensibly ‘passive' investments, the recession has resulted in deterioration of trust between investment partners. This is very likely to affect the basic fund model significantly.
The real estate fund management industry: threats and opportunities
Global political uncertainty has been pointed out as being one of the major threats to the whole industry.
Investors are very concerned by the current political and economical environment and its impact on the real estate industry. However, they view the uncertainty also as an opportunity to shift the relationship between investors and managers towards a new interaction model.
It was surprising that thought leaders were almost all focused on exceptional global circumstances: the unpredictable direction of global politics and economy. In this context, investors are reluctant to make new investments and generate innovation, and they are avoiding exposure to risk because of uncertainty surrounding regulations.
At the same time, this situation is creating a ‘survival of the fittest‘ momentum: competition within the industry is consolidating and becoming more limited. It appears essential to move forward with the right strategy and partners, and investing in knowledge and expertise affords a clear advantage. This is particularly true in light of worldwide urbanisation, particularly in the BRIC countries and other emerging markets.
‘Threats and opportunities from table perspective' summarises the summit thought leaders' ideas on the threats and opportunities within the industry.
Topic 1: Threats and opportunities: pessimistic industry outlook
The group was generally pessimistic about the outlook for fund investment. They noted first that many countries around the world are consumed by concerns about the concentration of income. This threat has several implications for real estate including hard-to-predict taxation changes, land usage restrictions, and political uncertainty. The thought leaders also pointed out that large remaining amounts of maturing debt will negatively affect most sectors. Although forced refinancing may create additional investment opportunities, fiduciary investors probably won't be able to participate in these speculative projects. A similar concern is that the wall of closed funds created in the mid-2010s will soon require new equity injections.
Topic 2: Threats and opportunities: the opportunity behind the threat
On the topic of broad threats and opportunities for the fund model, an overarching theme quickly emerged: there are many opportunities for shrewd, prudent, and diligent investors. For example, while the current social and political unrest in Southern Europe was identified as a threat, this turmoil creates opportunities for careful investors looking for value. Likewise, the upcoming wave of additional regulation soon to hit Europe is a threat, but, by altering the investment landscape, it also creates new opportunities for investment. Even today's biggest threat to the fund investment environment - European bank financial distress and the lack of liquidity and structured debt available - comes with a silver lining. Investors who do not need to rely on bank lending will see new deals come to market.
Topic 3: Threats and opportunities: the uncertainty around political developments
The new regulations that came out of the sovereign debt crisis are perceived as an important threat to fund investment. While these regulations may placate public opinion, they are detrimental to investors. Upcoming elections and the possibility of regime change also cloud the investment environment.
Governmental instability has also become a major concern for real estate investors. For the time being, Italy is stabilising and its image is improving in the eyes of real estate investors. Additional opportunities exist in countries where the government has implemented favourable investor laws and regulations. These include tax breaks for new investments and streamlined approval processes for new developments. Another significant economic threat is a possible bubble within core real estate assets in first-tier cities. At the summit, the general consensus was that a bubble is beginning to form, but core assets remain vital to institutional investors, and they should therefore hold their ground in the near term.
Economic opportunities include the low interest rate environment, the growth of emerging markets and the possible increase in inflation. The low interest rate environment is making debt very affordable and attractive when available. Emerging economies in Europe (e.g., Turkey) are showing strong growth and increasing appeal for real estate investors over the next five years. Furthermore, increasing inflation rates could elevate real estate values.
Industry-related threats include the low-yield environment and limited access to capital. The low-yield environment, especially with respect to core assets, could become a real problem when interest rates begin to rise. In addition, limited access to capital could hamper new real estate investment and the ability to refinance upcoming obligations. Regulatory uncertainty could also keep many investors on the sidelines for a while longer. Over the past few years, regulations have changed significantly in order to reduce the likelihood of a future financial and debt crisis. This makes developing properties more costly and approval more uncertain. It also means that funds must have more local market knowledge. To add to the uncertainty and risk, the timing and implementation of new regulations is often difficult to determine. However, increased regulations could lead to more transparency. This could be advantageous to local fund managers who are better able to work with local regulators.
Topic 4: Threats and opportunities:
Survival of the fittest
The fund model must confront the following three dominant threats:
• Macroeconomic risk and volatility;
• Political uncertainty;
• Currency risk.
On the opportunity side of the ledger, only the very best managers have survived the crisis: this bodes well for the future performance of existing funds. In addition, the protracted slowdown suggests that we are due for a solid recovery. Somewhat paradoxically, a continued lack of transparency creates opportunities for diligent investors to find profitable opportunities.
Topic 5: Threats and opportunities: understanding macroeconomic heterogeneity is paramount for successful investors
The thought leaders in this group underlined macroeconomic threats: slow (or nonexistent) GDP growth, unemployment and high debt levels. While some macroeconomic trends have a global reach, each individual country is affected differently and to a different extent. It is imperative to understand this macroeconomic heterogeneity to make successful investment choices. For this reason, the expertise of fund managers and local partners is essential. Macro-economic turbulence is likely to increase the regulations that constrain the business of banking. Bank-provided liquidity is tightening as a result of the new regulatory environment, which opens the door for more investors to participate in global projects. This trend further increases the need to improve the fund model.
The threats and opportunities specific to real estate fund management go well beyond those described above.
Focusing on the details - Roundtable outcomes
This section delves into the specific topics addressed by summit thought leaders at their assigned roundtable. These topics were selected because of their prevalence within the real estate fund management industry.
Topic 1: The benefits and risks of joint ventures and club deals
Outcome: Increasing polarisation across different investor classes; JVs and club deals are difficult to implement successfully
The first group of thought leaders discussed the benefits of the increasingly popular syndicate approach to investing.
The overriding sentiment at the table was that the risks and benefits of JV and club deals are increasingly polarised across different investor classes. Large investors can operate on a scale that can make direct, joint investments sensible, but smaller investors cannot achieve their diversification goals outside of the fund model. JV and club deals have an obvious benefit: they allow the LP greater control over investment decisions. This includes the implementation of investment criteria both at the entry and exit stage, which reduces timing uncertainty and increases transparency regarding the GP's investment choices. An additional benefit is that LP and GP incentives are more closely aligned in JVs.
In spite of these benefits, several participants believed that the success of JV and club deals depends upon a very tightly and well-defined investment strategy, agreed upon before the venture is undertaken. In addition, it can be prohibitively costly to put together a JV deal. It can also be a real challenge to build consensus among multiple decision-makers.
All told, thought leaders generally agreed that while JV and club deals offer myriad benefits, they are difficult to implement successfully. These structures do not make economic sense for smaller investors. These investors lack the resources and experience required to understand multiple markets well enough to confidently implement multiple JV and club deals. Moreover, small investors are unlikely to achieve sufficient diversity in terms of asset type and geography because they engage in fewer large JV and club deal investments. It is also very challenging to build consensus among diverse JV partners. Generally, pooled funds have a clear advantage over JV and club deals in their ability to react decisively to changing market conditions or investment opportunities without having to reach a group agreement.
Topic 2: Striking the right balance between manager discretion and investor control
Outcome: A real need to align the incentives of multiple investors
A second group of investors reflected on how best to balance manager discretion and investor control, two seemingly incompatible goals.
The roundtable's assigned topic - the tug of war between manager discretion and investor control - is also a major threat to the fund model. Investors want managers to clarify their fundamental goals and their approach to deploying funds. Managers must become more transparent regarding their target mix of countries and sectors, their leverage preferences, the part of the risk-return frontier where they aim to operate, and overall fund-size goals. Investors also recognise that there needs to be a fine balance between setting these predetermined goals and strategies and allowing the fund managers to apply their local market expertise to achieve the desired returns.
Thought leaders at this roundtable agreed that investors are unable to manage a day-to-day level of control of their real estate investment, as they are not capable to manage directly the asset. Managers need to maintain a certain degree of flexibility to be able to respond to changing conditions. They should not, however, be given free rein. Any change in strategy for a given type of investment decision should require the approval of key LPs. Furthermore, these LPs should be given the option to withdraw their investment if the fund approach changes significantly. Skilled managers remain key to a successful fund strategy. However, new checks and balances must be put in place to safeguard investors' interests.
These thought leaders also agreed that the traditional fund management model fails to properly align the incentives of investors and managers, as well as those of different investors. Many investors seek to influence fund management at the strategic level. They want to see managers invest directly and significantly in the projects they take on. A manager's stake must be large enough that, if performance deteriorates, they would risk significant losses and have a disincentive to walking away.
There is a clear need to align the incentives of multiple investors. Fund partners frequently change, and new partners may not share the same goals and objectives as the incumbents. It is also important to establish and decide upon barriers to entry and exit in advance. This way, the initially established goals and objectives will remain the same unless the market dictates change and all incumbents agree.
Topic 3: Which markets and sectors offer investors the best opportunities in the euro area crisis environment?
Outcome: Germany, the UK, core cities, offices and retail appear to be the best opportunities in Europe today
A third group of investors and managers was asked to identify the best opportunities in today's euro area. The group agreed that core assets remain important and are preferred by institutional investors. The best investment opportunities continue to be found in Germany and the UK , core cities, offices and retail. Some thought leaders suggested that funds must further diversify across core markets.
In the midst of current market turmoil, investors can find opportunities in alternative markets and strategies. The first recommendation was to diversify further by moving away from core assets to B/B+ office space in outer London or even second-tier cities such as Manchester. The second recommendation was to target luxury hotel development in Turkey. There is significant demand for luxury hotel rooms in Istanbul due to the country's increased tourism and strong economy. The third recommendation was to look to emerging Eastern European countries such as Poland or Albania. Even though most institutional investors have yet to consider these markets, their growth prospects are very strong and their governments are becoming increasingly stable.
Topic 4: Blind pool funds: Do they have a future?
Outcome: Blind funds will function as an important class for niche and opportunistic investments
The future of blind pools was the focus of a fourth roundtable.
The term ‘blind pool' means different things to different institutional investors. An overarching characteristic is that blind pool funds are raised without first committing to specific deployment plans and properties. Investors are provided only with a broad strategy and portfolio mix. There will always be a place for blind pool funds so defined in the investment menu. Blind pools are better equipped to capitalise on niche markets. Given the fund's nature, it must rely heavily on trust and time-tested relationships between LPs and GPs. Due diligence and transparency are paramount throughout the fund life. In the current environment, whether the blind pool model is a sensible way to invest depends strongly on the target market.
Current blind pool structures tend to fall within the category of short-term investments (less than five years), and can vary in monetary size. Blind pools are unique in the way they can flexibly meet the demands of very different investors. For some, this could mean extending the duration to longer-term investments. For others, this could mean more LP influence and direct representation. Overall, the roundtable group agreed that blind pools should not be used for core investments, but rather as vehicles of choice for opportunistic niche investments. This should translate into a dynamic form of blind pools that change in duration and size based on particular markets and investment strategies.
It is very important to outline fund goals clearly. Before the recent downturn, leverage was often used to boost returns and increase fund management performance. Basing performance on return created a system that encouraged risk taking. To guard against a similar drift in the future, it will be important to change performance metrics and management compensation.
Topic 5: Can value still be found in core assets?
Outcome: A global flight to quality has caused compression of cap rates, but core investments remain safe and reliable.
A fifth group of thought leaders tackled the perennial question of whether value can still be found in core assets. Has the flight to prime real estate quality that followed the crisis run its course?
Regarding the prospects for core assets, the conversation first focused on the meaning of ‘core'. Does it refer to a building in a core location? Or a new trophy building in terms of construction quality, value, and size? A building with stabilised income? These are three possible definitions. Semantics issues, core prospects also vary greatly across locations. For example, core assets can be difficult to find in Northern Europe because of a lack of construction and willingness to sell by current holders.
The global flight to quality has caused a compression of cap rates that lowers the income prospects associated with these assets. As a result, investors are considering alternative investments, but they are proceeding with caution and very conservative gearing levels. Investments in new, emerging markets demand a keen understanding of local conditions in order to avoid costly mistakes.
On the positive side, investors say that the increasingly transparent private market is helping to alleviate their concerns about alternative investments. The private sector is providing superior benchmarks and allows investors to track performance better than ever before. In sharp contrast to the KPMG survey results, thought leaders also felt that real estate investment trusts (REITs) are excellent alternative strategies for investment. These investors cited strong REIT performance in the US and their growth in Europe.
A vision towards 2017
No thought leadership meeting is complete without addressing the outlook for the near future. Group members were asked to provide their thoughts on the future of the real estate fund management industry towards the year 2017, both generally and from the specific perspective of their roundtable topic. The essentials of their ideas are described below.
Topic 1: Outlook - An advantage for large investors only
Looking forward, a growing number of large investors are likely to opt for the club and JV model while small investors will stay with pooled funds. Overall, the consensus is that there will be a smaller proportion of fund investment over the next five years.
Topic 2: Outlook - Expertise in house
The group felt that over the next five years, incentive alignment issues would lead large investors to act more independently from fund managers. These large investors will form their own syndicates and develop their own investment platforms, which may eventually lead these limited partners to hire fund managers internally. In other words, LPs may attempt to bring management expertise in-house. There is also a danger that once the cycle turns and the market returns to normalcy, the lessons learned from the crisis will be forgotten and the fund management model could revert to old habits. However, thought leaders assign little probability to this scenario and expect instead that a more mature, improved and refined fund management model will emerge.
Topic 3: Outlook - Growing number of core countries
Looking ahead five years to 2017, the investment environment will be healthier, albeit only slightly. It will take a long time to work through the area's sovereign debt problems. Emerging economies such as Turkey and other Eastern European countries will become part of the mainstream and more acceptable to institutional investors. Overall, the number of core countries could grow, increasing the size of the core segment.
Topic 4: Outlook - Flexibility and speed to deploy capital and take advantage of arbitrage
There was a consensus that blind pool funds will continue to exist as long as LPs and GPs value the opportunities this particular investment structure presents. For niche markets, blind funds provide the freedom and flexibility to deploy capital and take advantage of arbitrage. While the existence of blind funds is guaranteed in the near future, their structure must mature to increase trust and transparency between investors and managers.
Topic 5: Outlook- Timelessness of core fundamentals
Overall, fund managers and institutional investors do not seem to be straying from core assets. While core investment opportunities can be difficult to find in certain countries, these investments remain safe and reliable. Investment conditions are not forecast to improve significantly over the next five years, and core real estate will continue to dominate the real estate food chain. Core fundamentals are timeless: in all markets, people need places to live, work and buy goods. Core real estate should remain a bastion of strength.
The basic message of the RE-Invest summit is that the real estate fund management industry has suffered and needs to adjust with certain consolidation ahead. However, the overall outlook for the industry is positive in the coming years.
Having said that, thought leaders are quite aware that the industry is facing major internal challenges, but there are also a number of unpredictable threats. These threats derive from external and incalculable events related to global politics and macroeconomic changes (caused by the different rates of development in Europe, the US and Asia).
Investors will have to be very attentive and flexible to respond to new situations on the global market. Lessons learned the hard way during the recent crisis will yield a more mature, flexible and resilient approach to intermediated lending. If these RE-Invest summit conclusions are accepted as the new face of an evolving fund model, they may give institutional investors the very flexibility they need to capitalise on new opportunities in the world of global commercial real estate.
The original report was produced for Reed MIDEM by Wisconsin School of Business and Swiss Design Institute for Finance and Banking at the University of Zurich