Since 2007, the real estate market has experienced unprecedented conditions characterized by busts and booms. The market volatility and liquidity crisis resulting from the 2007 property market followed by the increase in property values before the crisis, led to a significant fall in property markets (IPF 2009). The real estate capital values fell by almost 50% from their peak to reach a trough thus affecting a lot of customers and financial institutions in Europe (PWC 2012, p.2). Part of the real estate that was adversely affected by the crisis is the unlisted real estate funds market.
By definition, unlisted real estate funds are also referred to as closed-end real estate funds. The funds have no private equity structure and are usually not traded on any stock exchange. Examples of unlisted real estate funds include private REITS, property unit trusts, and unlisted REITs (INREV 2012).
The unlisted real estate funds are also referred to as non-listed real estate funds. The current paper explores the appropriate changes in the operation of the unlisted real estate funds market. The paper also draws examples from the experiences of the last boom and bust in the UK. It also gives an overview of the issues experienced in the boom and the bust, followed by the appropriate changes and a summary of the same.
Before dealing with the appropriate changes, it is important to revisit the issues faced by the property market when it underwent a period of boom and bust. Some of the issues include limited transparency by managers to the investors on the changes in the market because of the existing opaque structures. Instead of delivering on performances directly to investors, managers used high fees to weigh against the acquisition of assets (Harrington 2010).
The two issues broke confidence and trust in the real estate market. Risk management practices and poor corporate governance were witnessed since property risk strategists, property evaluators, insurance companies, and brokers were not transparent with financial institutions as expected by the law.
In addition, there was also high dependence on high leverage which was adopted to supercharge unlisted real estate performances rather than depending on the skills of the managers in real estate to drive the performances (Harrington 2010). An appropriate performance benchmark should have been set to ensure that the manager was rewarded based on the valued-added performances availed to the investors.
One of the major practice changes deemed appropriate for the operations of the unlisted real estate funds is for managers and investors to be more aware of the investment criteria used. This enables them to choose the most appropriate funds to invest in. For instance, investments should be frequently aligned with the managers’ ideas on the way they select non-listed real estate funds.
According to Van Cruchten (2007, p.21), the fund style has become one of the most important aspects that depend heavily on the manager’s or investor’s appetite for risks. As a result, an investor should be well informed of the risks involved before getting into the unlisted real estate property investment. Such a decision should also be informed by the skills and advice of the fund manager.
A major characteristic experienced during the boom and bust was poor communication among the managers and their investors. As noted by Van Cruchten (2007, p.22) poor communication in the real estate market leads to asymmetric information flow and market know-how, uncertainty and imperfect monitoring. This has a drastic effect on market compensation structures.
In addition, the non-listed real estate sector is mainly characterized by low liquidity, limited transparency, and limited information availability on the performance of the market which investors may not be aware of. Furthermore, several parties are funded in the non-listed real estate whose interests are different from each other. Therefore, an appropriate change would help to put in place mechanisms that allow the flow of information on the market performance and operations from the managers to the investors (Harrington 2010).
As noted in research carried out by PWC, fund managers are faced with a lot of pressure from investors regarding the commitment or provision of the funds (PWC 2012, p.26). From an economical point of view, all business ventures are characterized by business cycles and the pressure may come when the cycle has hit a trough. Since the market depends highly on the lack of liquidity as a trade-off, it is important to commit the funds at the most appropriate time.
In addition, investment commitment by investors should be left open since fund managers need to evaluate the pool of investments before selecting the investment option to proceed with. We also need to remember that unlisted or closed real estate funds are associated with high risk. Therefore, the commitment period should be left open for both managers and investors to enable them to have a look at the risks involved (PWC 2012, p.26). This would also allow investors to deploy their capital in better opportunities if the fund manager proves to be invalid.
Confidence and trust in the manager are two major elements in real estate market operations. In other words, fund managers have a fiduciary duty to play once investors commit or provide funds. Close-ended funds play the role of offering the fund manager a fixed period opportunity in which they are able to exploit opportunities available in the market and also engage in active asset management (PWC 2012, p.27).
Depending on the track record of the fund manager and the skills that he/she possesses, predictions are made and investments carried out. Therefore, there is a need for investors to understand the skills of the fund manager as well as their track record. This would help the investor to determine the interests of the fund manager with respect to his or her finances. In addition, it also helps in determining the mode of compensation or compensation contract to be adopted.
Just like in any other profession, the skills possessed by a fund manager are important in delivering positive results in any venture. Capital management skills are not enough since an excellent real estate fund manager should also be an asset enhancer (Harrington 2010). This implies that they should create value and add value to the assets during the property’s lifecycle.
As noted in the report by PWC (2012, p.27), the behaviors of both the fund managers and investors have since changed following the recovery of the real estate markets. For instance, the report notes that a portion of the fund manager is engaging in an active role to ensure that the interests of investors are disposed of in the closed-end funds.
Compared to the past, fund managers in closed-end funds are now helping investors to engage in secondary transactions that are not driven by the desire to make high commissions but by the need to retain investors. This would help investors to invest in the future and also offer a choice for future incoming investors. As opposed to the past when a non-alignment of interests existed between investors, fund managers are now opting to work with like-minded investors. This has helped to increase trust and confidence hence leading to improved transparency levels.
Van Cruchten (2007, p.24) notes that the compensation structures of non-listed real estate are characterised by limited transparency and poor corporate governance. As noted earlier, one of the major experiences of the boom and bust period in the property market is the issue of poor corporate governance and transparency which led to poor management practices.
The compensation systems which form fee structures are part of the corporate governance framework which has to be transparent. In addition, the corporate governance framework should also abide by the prescribed terms of ethics. As observed by PWC research , one of the major steps being taken by fund managers to instill and improve transparency and governance is by “making it easier and less financially penal to sell fund interests as new buyers are able to get a much clearer idea of what they are acquiring” (PWC 2012, p.28).
We continue to witness a heated debate regarding the issue of remuneration of the fund managers (Harrington 2010). During the boom and the bust period, the managers’ fee structures were biased especially towards very high front fees, management fee, and on-going management fee which were considerably smaller, and the high performance fees which were based on the performance of the fund managers.
The implication made is that fund managers focused more on the funds under management, as well as on the assets gathered instead of focusing on the on-going management and assets exit with the aim of maximizing investor’s returns (Harrington 2010). This means that some of the fund managers during this period were more concerned in their remuneration than the interests of the investors.
The performance fee should be paid to the fund manager on the basis of the returns that an investor gets (Van Cruchten 2007, p.30). However, thus was not the protocol that was followed during the boom era and hence the low levels of trust and confidence.
The fee structure of non listed retail funds is asymmetric which is considered to be inappropriate (Van Cruchten 2007, p.30). Managers are either rewarded through relative performance or through absolute outperformance. Under the absolute performance option, the fund manager is compensated based on the set hurdle rates which are a reflection of the investment strategy.
On the other hand, relative performance is based on a market benchmark which has both negative and positive performance. All these are neither wrong nor right but the performance benchmark should be a reflection of the risk-return tradeoff based on the appropriate hurdle set (Harrington 2010). In other words, the manager should be rewarded for the value added on the assets or on the basis of the value added performance availed to the investors.
According to INREV (2012a, p.9), the fee structure is subjected to other funds such as debt management fees, custodian fees, and acquisition fee which vary also. However, the development of the new INREV Total Expense Ratio has given investors a break through while comparing the fee associated with their funds. This will ensure a more symmetrical fee structure is adopted by the fund managers.
According to INREV (2012, p.5), the current classification style was introduced in 2004 by the INREV. Because of the cyclical changes in the real estate market, the style has proven to be inappropriate. In addition, the leverage objectives and the IRR have proved to shift depending on credit availability and the market state which would lead to drifting of the funds. As a result, it has been proposed to adopt a more robust classification of the European non listed property market funds (INREV 2012).
Therefore, changes should be made which based on the new INREV classification style which is based on bundle of risks factors. This would allow double counting and the assumption that the assessments carried by fund managers are utterly correct. The adopted variables will allow simplicity and transparency in the non listed real estate fund.
The major three fund risks factors included are income indicator, development exposure, and leverage (INREV 2012). These three variables will make it possible to classify non listed real estate funds and expose them to lesser effects of the effects of the market changes.
The leverage variable will allow the use of loan-to-value variable instead of using the target loan-to-value which is commonly used by the investors while analyzing the associated risk factor in assets portfolio (INREV 2012). With regard to the development exposure, refurbishment shall be excluded but redevelopment and development activities will be included during the calculations.
INREV (2012a, p.6) note that non-listed property funds engage at least three different investors who jointly invest through a fund manager. Although this option is deemed as simple, it proved to be a bit complex during the property market crisis because of the strong alignment in the requirements of the fund manager and those of the investors.
The alignment was broken during the financial crisis since managers benefited at the expense of the investors, thereby reducing the urge by investors to invest. In addition, liquidity associated with the funds fell during the financial crisis which saw different investors fall apart since some could not match the calls for fresh equity while others lacked expertise and decisions required in resolving the issues (INREV 2012a, p.6).
As a result, the level of education and expertise as well as like-mindedness has been considered to avoid such problems of poor expertise and alignment of interests. Investors are investing with counterparts who have the same interest as well as expertise in unlisted property funds.
Traditionally, fund managers had a discrete role over the investment strategy and the fund investment (INREV 2012a, p.6). However, this has since changed given that investors’ levels of involvement have increased. In addition, there has also been an increase in the level of transparency and funds governance. Currently, Investors engaging in unlisted real estate funds are demanding high levels of control over their funds than before.
In addition, according to INREV (2012a, p.8), INREV has put into place guidelines which would increase the levels of transparency than before. So far, more that 97% of funds in 2010 adopted over 50% of the transparency enabled guidelines which are a sign of commitment. Also, the availability of a database which lacked before, gives a proper overview of the market in terms of its composition and its size.
In terms of liquidity, this was a major problem during the financial crisis since little interests were experienced as well as wide bid price for secondary positions. As a result, most of the funds were caught in the financial crisis trap as they could not be redeemed (PWC 2012, p.35; IPF 2009). This has led to demand for low debt levels among the investors.
The boom and the bust have played an integral role in ensuring that changes are incorporated in the operation of the unlisted real estate funds market. Some of the appropriate changes include the involvement of the investors in the investment to control the way their funds are invested. Others include inclusion of investors with same interests under the same fund manager.
Performance, education, skills and the expertise of the fund manager have also been heavily scrutinised in order to ensure that past experiences are not repeated. Through the INREV, new styles of classification based on risks bundles have been proposed, along with operational guidelines thought to increase levels of transparency.
Better communication, adequate corporate governance, the adoption of a fee structure that is aligned to the interest of both the manager and investor, and better management leverage are some of the strategies that have been adopted. Fund managers have been on the forefront in ensuring that levels of transparency and proper governance are increased. Lastly, there has been an increase in demand for proper flow of market information from fund managers to investors.
Harrington A 2010, Unlisted real estate funds – back to basics for SMSF investors. Web.
INREV 2012, INREV style classification: Revised version, INREV Research & Market Information, Netherlands.
INREV 2012a, White paper: INREV Guide to non-listed 2012, INREV, pp.1-19.
IPF 2009, The evolution of the market for indirect investments in commercial property, IPF Research Programme Short Papers Series, London.
PWC 2012, Unlisted funds: Lessons from the crisis, PWC, Report for The Association of Real Estate Funds.
Van Cruchten, J 2007, Fee structures and managerial behavior in non-listed property vehicles: Is it worth the pay (n)?, Thesis, Maastricht University, Hague.