Appropriate Changes in the Operation of Unlisted Real Estate Funds Market - Assignment Example

?In the light of the experience of the last boom and bust, what (if any) changes in the operation of the unlisted real e funds market do you think are appropriate? In the last five years, the real estate markets have seen unprecedented conditions. “Real estate has been at the forefront of the financial crisis” (corporate-engagement.com, 2011). While assessing the impact of the global financial crisis on the unlisted real estate fund market, the five-year period before 2007 cannot be ignored as it laid the basis for the conditions that occurred since the onset of the global financial crisis in 2007. From 2002 to 2007, there occurred yield compression, the capital values of real estate rose rapidly, and the availability of capital for investment in the real estate increased drastically. “The rapid rise in property values was already losing momentum prior to the liquidity crisis of the summer of 2007, which in turn triggered a significant downturn in both the broader economy and the property market” (pwc.co.uk, 2012, p. 4). The global financial crisis has severely tested the managers of unlisted real estate funds in a whole range of ways that include but are not limited to investor activity, liquidity management, vacation accuracy of indirect as well as direct holdings, availability of asset, pricing, debt management, investor communication, and unit pricing. All of this has happened in context of the economic instability along with market commentary and an increasingly subjective media. In spite of the fact that the global financial crisis has receded and the flow of money in the unlisted real estate funds has started to become normal, yet much needs to be done to resolve the process of selectivity by the investors. The movement of capital because of the cost of withdrawal of the funds has inertia as an inherent feature. The under-performance of open-ended funds by few investors has enabled them to withdraw funds and use the secondary market for selling interests. In some cases, the investors have made a joint effort to change the funds’ manager. The complete effect of judgment of the investors upon the fund managers can take years to play out rather than few months because the deployment of new capital is the decision of the investors. Fund managers who have not been able to satisfy their investors may find it difficult to raise new funds. Collection of the new funds makes the depiction of success and loss among the fund managers more apparent. “Unlisted funds typically are structured as a private equity fund” (Huibers, 2012, p. 5). Since the onset of the global financial crisis, there has occurred immense change in the landscape of real-estate private-equity in terms of drawing out of numerous financial institutions from the unlisted real-estate market and sale of platforms (Yue et al., 2010). During the global financial crisis, the investors were struck into funds which they could not find escape from easily. After gaining this experience, many investors are looking for more flexibility in the real estate investment. Cash-rich investors wanted to increase their equity in an attempt to keep the bank from seizing their portfolio in cases of breaches of loan-to-value. Fund managers realized that some investors were not able to match the investments. The interests became so divergent that it was hard to reconcile. As a result of this, many investors are nowadays looking for like-minded co-investors for partnership with them so as to be able to reach agreement easily in the times of conflict. This trend reduces the size of the investors’ clubs established to invest money in specific portfolios, properties, and redevelopment projects. There are also certain investors who are seeking funds to get them structured in such a way that increases the liquidity. Investor registers are also being made by the large pooled funds to improve communication among the investors. Debt and the way it was dealt with by the fund managers during the last boom and bust is an important issue. Debt was readily available in the pre-2007 boom. “During the last economic boom, most business owners would have preferred a higher mix of debt to equity as debt was readily available, interest rates were lower, companies had more accurate earnings forecasts, and earnings tended to rise over time” (Nemethy, 2009). In fact, debt also played an important role in fuelling the boom. As the debt was readily available and there was competition in the market for the existing assets, fund managers particularly those who were closed-ended had to bear a lot of pressure to borrow so that returns can be enhanced for remaining competitive. “As loan-to-value ratios increased, as did the pressure on closed-ended fund managers to borrow, the amount of investor capital deployed for each acquisition fell. Fund managers found themselves buying more and more assets in order to invest the capital committed by investors” (pwc.co.uk, 2012, p. 35). The ready availability of debt which was a significant trait of the preceding boom reversed during the liquidity crisis. In addition to that, the drastic decline in the real estate values caused many borrowers to breach the loan-to-value covenants. The impact of debt during the global financial crisis yields many lessons for the investors and their advisors. Some fund managers had foreseen the threat of fall in the value of real estate market, as well as its pressure on the loan-to-value covenants, and thus drew down the additional capital from the investors in an attempt to pay the debt. The situation was more complicated for those fund managers who had failed to anticipate the fall in the market. Certain changes can reduce the threats of debt discussed above. Since it is riskier to borrow at the market’s top than at its bottom, it is advisable to make the gearing levels variable across the cycle. It not only has appeal, but also techniques to operate it can be proposed. Since the closed-ended funds cannot get back to the investors so that new equity can be raised, it is advisable to make the fund documentation such that it enables the managers to raise new capital. Nevertheless, certain other issues can be raised along with it such as it undermines the rationale of the model of closed-ended funds. Owing to the difference between the views of investors and managers, the best option in this area is to enable the market to develop the products. The decision will rest upon the investors who would deploy their capital in the funds with appealing characteristics. Debt’s use in the open-ended funds is an important matter. The investors’ tendency to request their equity’s return is not consistent with the management of debt. On the other hand, the investors’ tendency to draw the new equity down eradicates certain issues linked with the model of closed-ended fund. There is a lot of variation between the timescale over which the capital in the semi-open-ended funds and the open-ended funds can be withdrawn by the investors. The best outcome in this case is providing the investors with a variety of offerings so that they can vote with their own feet. One of the positive outcomes of the global financial crisis is that it has made all real estate fund managers realize the importance of putting the interests of the shareholders first since they are the fundamental source of money that is invested. The global financial crisis has reminded the investors the significance of having the right manager, as well as fund. In the past few years since the onset of the global financial crisis, numerous DIY Superannuation investors in the listed as well as the unlisted real estate funds have been burned. As a consequence of this, both investors and their advisors will apply a new kind of scrutiny to the real estate fund managers. Generally, the investors are aware of the cycles in the markets, and the fact that the investment values keep fluctuating. The quality of being upfront in the manager makes the investors more pragmatic, and enables them to be more articulate in their reasons of displaying under-performance, as well as their demonstration of the plans of action to improve the performance. Trust and confidence are two fundamental elements that lay the foundations of the markets. Although there is a considerable population of the real estate managers who have managed to fulfill their commitment of creating stable wealth, yet certain high profile casualties have still been noticed. Issues commonly encountered by the managers and their unstuck funds include but are not limited to opaqueness of structures having insufficient transparency, high leverage employed to super-charge the performance instead of depending upon the competencies of a real estate manager, poor communication and coordination with the investors, and poor risk management practices. Manager remuneration is a potential issue that has attracted a lot of discussion and debate after the recess of the global financial crisis. The fee structure in many unlisted real estate funds was inclined towards fees that were high front end, while the management fee was smaller, and the managers would get the performance fee even when all they did was ride the real estate boom. On-going management was poor and assets were not timely utilized to enlarge the investor returns. Instead, the focus was on the rolling out of fund one after another and the growth of funds under management. The diligent managers often draw out of the bidding contest in a competitive market because of their inability to justify the price, as a consequence of which, the unlisted real estate fund managers get the opportunity to charge reasonable and justifiable acquisition fee. The prime objective should be achieving the appropriate balance between the fee to obtain the real estate and that to outperform for an investor over the asset’s life. The more bade-ended the fee, the better it is. The managers can share the outperformance when the investors do well. The method of rewarding the manager is a cardinal issue with the structure of performance fee. The manager can either be given absolute outperformance or relative performance considering the benchmark of negative and positive performance in the market. There is no answer that can be absolutely right or wrong. The concept is to ensure the establishment of the performance benchmark at a reasonable hurdle which encapsulates the strategy. The manager can be rewarded with the fee for the delivery of value-added performance to the investors. “Despite unlisted real estate’s deep and long correction, it continues to be a large and attractive asset class for many investors in every region” (peimedia.com, 2011). Therefore, a new funds classification has been formed by the European Association of Investors in Non-Listed Funds (INREV). The aim of this funds classification is to develop a strong, sustainable, and workable classification for the unlisted real estate funds market. It is based on bundles of risk, and is a significant development for the unlisted real estate funds market as it provides the funds managers, investors, and their advisors with more explanation and clarity that they can utilize to improve their investment strategies (propertyeu.info, 2011). “There are many risks that impact the non-listed real estate funds market, due to the heterogeneity of real estate assets and the variety of management strategies that can be applied to them” (INREV, 2012, p. 5), though INREV has kept its focus upon the risk factors which are the prime determinants of styles. According to INREV, factors on which the styles were originally based including gearing and the internal rate of return (IRR) have now become obsolete measures. Sharing his views about the new funds classification with the IP Real Estate, the chief executive of INREV Matthias Thomas said, “These variables proved not to be robust over time, and we found that the framework was no longer synchronised with current market conditions. In fact, IRR is really about the price of risk. Returns and leverage objectives have shifted over time, leading funds to drift across defined boundaries. The bundle of risks approach is more comprehensive and provides stronger data on which to base enduring classifications” (Thomas cited in IP Real Estate, 2011). Core funds are now classified on the basis of these three operating variables (along with their percentages); the redevelopment exposure’s target population (5 per cent), target percentage of investments that do not produce income (15 per cent), and the target return that is retrieved from the income up to (60 per cent) (Property Investor Europe, 2012). The new funds classification has obviated the need to take the loan-to-value consideration into account to classify the funds as core. Concluding, the global financial crisis has had immense impact upon the unlisted real estate funds market. Although the investors and funds managers had to go through a lot of tough time, yet this provided them with an opportunity to learn from their mistakes, and alter the business practices to ensure minimal damage in the future under similar circumstances. Real estate is a continuous business that requires competencies of development, obtainment, management, and leasing of the real estate. The importance of capital management skills cannot be overemphasized, though the capital management skills cannot promise consistently strong performance to the investors unless the right assets are acquired. In order to improve their efficiency, real estate fund managers need to be able to enhance the assets and create value using the skill to add value at every point in the asset’s lifecycle. Having faced a lot of challenges during the global financial crisis, and learnt many lessons from it, the investors may reduce the risks and enhance the profitability of the real estate business by making more transparent and simpler structures, paying emphasis upon the sustainable income, improving communication, bringing more transparency, ensuring exemplary corporate governance, and improving the management of leverage. Survival and prosperity of the unlisted real estate fund managers depends upon their ability to adapt to the changes required by the investors of the real estate as well as their advisors. Fund managers and investors need to conduct dialogue with each other, which sustains into the future also. There is a considerable population of fund managers and investors who think that the collective memory in the real estate industry is short. Such issues can be tackled with continuing dialogue and debate between the fund managers and the investors. Increase in the investment opportunities worldwide and renewal of interest from the investors predict a bright future of the real estate fund market. In order to optimize on their ability to take maximum benefit from the new and changed environment in which the effects of the global financial crisis are reverberating, it is imperative that the investors as well as the real estate fund managers adjust to the changes. Investors ask for increased hold over the investments they have made in the real estate, whereas new challenges are created by the regulatory changes. Success of the investors and the real estate fund managers depends upon their adaptability to the new model. These measures if taken will help reduce the likelihood for the unlisted real estate funds market to be affected by the financial crisis again. References: corporate-engagement.com 2011, Real Estate, Governance, and the Global Economic Crisis, viewed, 27 June 2012, . Huibers, F 2012, Do infrastructure equities offer structural benefits to the institutional investor?, Amsterdam School of Real Estate, viewed, 27 June 2012, . INREV 2012, INREV Style Classification, pp. 1-15, viewed, 27 June 2012. IP Real Estate 2011, INREV updates classification for non-listed property, viewed, 27 June 2012, . Nemethy, L 2009, Debt versus equity in today’s financial climate, viewed, 27 June 2012, . peimedia.com 2011, The Definitive Guide to Real Estate Investing, viewed, 27 June 2012, . propertyeu.info 2011, INREV introduces new fund styles classification, viewed, 27 June 2012, . Property Investor Europe 2012, INREV refines fund styles to boost core/val-add split, viewed, 27 June 2012, . Pwc.co.uk 2012, Unlisted funds – Lessons from the crisis, viewed, 26 June 2012. Yue, R, Calvert, C, David, R, Sullivan, L, and Osborne, S 2010, Accessing the Asia real-estate story, Asian Investor, viewed, 26 June 2012, . Read More