INREV is aiming to overhaul its classification system of fund styles by launching a new analysis framework. Christine Senior speaks to the association, along with investors and fund managers, about the difficult task of bringing clarity and consistency to Europe's unlisted real estate fund sector

The European Association for Investors in Non-Listed Real Estate Vehicles (INREV) set itself a daunting task in trying to come up with a framework for defining styles of unlisted real estate funds that brings clarity and standardisation to the sector. It was never going to be easy to design a classification system that would remain valid for a multiplicity of jurisdictions, managers and fund types, whilst being sufficiently flexible to reflect changing times and conditions.

The world of real estate funds has evolved since the existing framework, devised in 2004, came into being. INREV had appreciated at the time that it would need revision, and that using just two factors - internal rates of return and leverage - would not be useful as a long-term means of classification. The effect of leverage, for example, has changed immeasurably since the more benign climate of five years ago. And current expected rates of return for the various styles bear no relation now to what could be expected then.

A number of initiatives produced information that formed the basis of the style framework. Cass Business School did some initial research. INREV set up its own Style Working Group, and members were consulted through workshops. The result was a white paper from INREV, which was followed by a consultation process, the feedback from which helped produce the finalised Fund Style Framework. INREV's conclusion was that style is a ‘bundle of risks', not all easily measurable. A pragmatic approach was needed.

"There were qualitative risks in style, such as how good is your fund manager? And there were quantitative ones that you could measure, like how much leverage you have and how many countries you invest in," says Andrea Carpenter, acting CEO of INREV.

"You could probably name 50 risk factors, but we were trying to find the ones that determined style. Leverage seemed at this point to determine style - you would never have a core fund with a very high leverage. We had lots of debates on which risk factors determined style. We set out those factors we could measure that captured 75-80% of the risk within style. We know it's not the whole picture - but we think they capture a good picture of risk in styles."

Now the relevant risk factors have been identified, the next stage is to analyse how they impact style. This will involve testing how the risk factors are being used in existing funds to see if they tally with the style classification managers are already applying to their funds.

"What we think will come out will be some typical characteristics for core, value-added and opportunistic," says Carpenter. "There will also be some analysis on whether these factors need weighting, because they are more influential than others in terms of how they affect style."

The testing regime is expected to involve at least 50 funds across a number of vintage years. The final stage of the process will be to produce guidelines that set boundaries for the different factors, to define typical core, value-added and opportunistic funds. Managers will be able to define the style of their newly launched funds. The classification will also be the basis for sub-indices based on style.

INREV's approach has been broadly welcomed. Eileen Fitzpatrick, director of alternative assets at the National Pensions Reserve Fund in Dublin, is positive about the initiative: "It recognises that the previous definitions were too narrow and that this new framework has a more defined focus on equating style with risk," she says. "It has sought to build on what are generally seen as accepted market classifications - ie core, value-added and opportunity. This should help investors in their attribution of performance and also provides a framework within which portfolio strategies can be built."

Nevertheless the industry is under no illusions that it would be hard to devise a system that meets the approval of all interested parties. Piet Eichholtz, professor of real estate finance at Maastricht University, regards the new framework as a big improvement on INREV's previous definition using only internal rates of return and leverage. "I'm pretty positive about it," he says. "It looks far more fundamentally at drivers of risk and does that in a pretty comprehensive way. INREV are moving in the right direction."

Nevertheless he does have some reservations, particularly in relation to factors that could have been included. Specific target countries for investment is one element.
"It doesn't say if you are in an OECD country or an emerging market," says Eichholtz.

"For this framework, it wouldn't matter if a fund was invested in class-A offices in London or in very bad offices in Kiev. That is a key contribution to risk. Secondly, if you are in London, what quality of market are you in: class-A offices in the City or class-C offices somewhere on the outskirts?

"And the third thing is it doesn't say which property type you are in, and some property types are more risky than others. Housing is not so risky but offices are more risky. All three relate to the product you are investing in, the quality of the product and the risk derived from that." Carpenter says that the issue of target markets was considered but then removed from the final risk factors.

"Countries came up as an initial risk factor and they were taken out at the final stage," she says. "What you have to ask about risk factors is: do they determine style? If you invest in the UK, does that determine whether it is a core or value-added or opportunistic fund? A lot of markets have opportunities across the risk return spectrum. We really didn't think it a defining factor."

Nevertheless information about target countries will be used in the analysis. "It may be that in combination with the other factors you need countries as a balancing factor within the analysis,"
says Carpenter.

Andrew Smith, chief investment officer at Aberdeen Property Investors, is positive on the initiative, while recognising the definitions can never please everybody. "INREV has taken a fresh look at it and said we need segmentation to classify the databank they run and to show this many funds are core, this many value-added, this many opportunistic, and to have some performance numbers to go with that," he says.

"In reality, not everyone agrees where the boundaries lie. If fund managers say we can't accept a structure as rigid as this, you can understand that. At another level it has to be rigid to do any meaningful analysis. Individual investors will look at each fund on its own merits. INREV's classification will be a helpful guide as to where it will be classified from a consensus perspective."

If the final outcome is an index for style it will be a useful tool for investors. It's possible to compare performance through country and sector indices, but the same can't be said for style.

"Once you start to dig a bit deeper in terms of investment strategies it's quite hard if you want to compare the performance of your value-add funds to the overall performance of those funds," says Ville Raitio, investment manager at ATP Ejendomme.

"That's something you can't do today. Of course, you would need to have clear definitions or a robust index so that everyone understands how one fund ends up in one category for performance measurement purposes and how it stays there. If it's left to managers' discretion I think you can have pressure of managing expectations and also maybe shuffling your fund from one category to another, so you look better against your peers. If we have clear set of definitions that should mitigate most of those issues."

ATP has an investment portfolio of around 25 real estate funds, mostly investing in Europe. Allocations are based on a number of elements, including style, sector, country and leverage. Sometimes this involves the pension fund making its own style definition of a fund that suits its own internal strategy.

"Sometimes the classification the manager comes up with might end up being classified in some other way in our internal modeling," says Raitio. "For example, in a new country we haven't invested in previously, we might take a careful stance and decide to classify it as an opportunistic investment rather than value-added, which might be the manager's preference."

Raitio is very supportive of the line that INREV is taking, although he has reservations on how the classification may work out in practice. "From an investor viewpoint, I think it's quite ambitious to try to capture each and every possible main risk in a single framework. That is a key point."

He cites diversification as an example of the difficulties he foresees in the practical application of the classification. "If you look at portfolio composition, it seems to suggest the more diversified you are the less risky you are," he says. "But, from an investor viewpoint, what is challenging is that risks are perceived differently. Every investor has a different portfolio."

He gives the example of a single country fund, which would be seen by the classification as being more risky, because it is concentrated on one market. "But, for example, if an investor doesn't have any investment in say France and they invest in a single country French fund, that is probably just going to diversify the investor portfolio.

So, it is a good thing, even though the risk framework would suggest that because of risk concentration it would be a more risky fund. The definition of risk is not the same for every fund."

This sentiment is echoed in the reaction of Rachel McIsaac, chief executive of Association of Real Estate Funds in the UK. She takes issue with grouping funds into risk bands: "Saying something is high-risk or low-risk so depends on the investor," she says. "What is high-risk to one person is low to another. I think not to take the investor perspective is the first issue."

The relative importance of leverage as a risk factor is something that has come under close scrutiny. The credit crunch has laid bare the effect of leverage. "We were used to using leverage as a one-way track only," says Hermann Aukamp, CIO of real estate for the Nordrheinische Ärtzeversorgung (NAEV). "Only now a lot of people see how important leverage is. I see this as something where the INREV definition will have to be discussed in the future."

Although Aukamp thinks the new classifications will be a great step forward, he is not convinced that all managers will adopt the guidelines. "Managers have been used to explaining their products in so many different ways; some called development funds core funds," he says. "But we wonder if all managers are willing to accept the INREV rules now and will they adopt this classification? We see a lot of managers who don't worry too much about INREV and still use their own home grown classification."

McIsaac is critical of the standard of transparency of data that European funds are required to produce through this classification exercise, because she believes it lags the level of transparency offered by UK real estate funds.

"If you look at the IPD UK Pooled Property Fund Indices, sponsored by AREF, published every quarter, you can look at every single fund member and you can look at all the track records, per cent by per cent," she says. "For the rest of Europe, reporting is mostly at country, not fund, level at the moment.

"What AREF are campaigning for is that all European funds bring themselves up to the same level of transparency and performance reporting that AREF member funds have been providing for 10 years now. It would be good if investors across Europe were afforded the same kind of clarity about the numbers that investors in AREF member funds are."

Smith at Aberdeen accepts that more transparency among European funds would be a good thing, but believes it is not really possible yet. "The criticism from AREF is a valid one," says Smith. "It would be nice to have detailed fund-level disclosure available to potential investors in continental Europe, as is in place in the UK. I think fund managers of some products in continental Europe would be willing to move to the same level, but there are plenty that aren't ready for that yet.

"Both views are valid. For INREV to say, ‘better style classification is needed and here are some rules', is acceptable and helpful. To say that provides the level of detail investors want is not true."

But McIsaac concedes that the task facing INREV is a difficult one, dealing as it is with multiple countries. "INREV is contending with many different jurisdictions and legal frameworks, which means their job is more complex than ours. Their style guide is definitely a step forward."