Property EU, October 2018
Evolution of European Open End Real Estate Funds
Open end real estate funds continue to be a popular product type. This is evidenced by the number of new open end funds being launched and the healthy levels of capital inflow enjoyed by the existing products on the market over the last year. What is causing the increased popularity of this product format and how are fund managers seeking to achieve competitive advantage in this rapidly evolving market segment?
Though the reported amount of capital raised varies from source to source, general consensus is that 2017 proved to be another record year for capital raising for non-listed real estate structures. . Coupled with this, all major sources have indicated that global institutional investors intend to increase their allocation to real estate over the coming years with many suggesting that they intend to target an allocation of over 10%. This is made more impressive considering the fact that global inflows for all asset classes has increased by 15%. Real estate not only has a higher allocation but more importantly a higher allocation of a larger total pot.
So where do open end core funds sit within this picture? - As it stands, core real estate constitutes over half of all assets held within all non listed structures. Over the last 3 years Funds have re-emerged as the dominant investment format by far. This return in popularity has been at the expense of club deals and joint ventures which have significantly reduced in popularity. Within the core funds universe, whilst the more significant number of funds in existence are closed end, a far greater portion of the assets under management are held by open-end funds.
So what has caused this increased popularity? This is topic that can be approached from three perspectives – the investor, the manager and the broader asset management industry.
From an investor perspective, challenges encountered in some more established fixed income asset classes have forced investors to seek other sources of fixed income to satisfy their needs. Inevitably, real estate has stepped up as a prime candidate for this producing solid, recurring income returns, inflation protection and diversification. In addition, thanks to the open end nature of these products, they also provide liquidity.
From a manager perspective, the case for open end funds is equally strong. All capital raising surveys suggest that big are getting bigger – despite the highly impressive inflows of new equity in 2017, it is estimated that as many as 30% of managers did not raise any equity at all. This is a feature set to increase as investor groups have signaled their broad intention to work with fewer managers. The combined impact of these trends mean that managers are obliged to establish a complete range of product types should they wish to grow their AUM in this environment. As such, whilst open end funds have historically been the remit of the traditional asset management firms, we are now seeing large and successful open end products being established by private equity firms that had historically focused more on the closed end space.
The perspective of the broader asset management industry further underlines the attractiveness of open end core funds in the current environment. Increased cost base due to challenges presented by the regulatory agenda, need for investment in new technologies to maintain competitive advantage, downward pressure on fees across all asset classes, the continued trend of the big getting bigger with 80% of all fund flows being collected by the top ten managers in 2017 – each of these industry wide issues further the case for large, evergreen funds that provide investors with stable risk adjusted returns.
It seems clear that open end core funds will continue to generate steady inflows of capital and look set to form a key component of the product range for all large managers. All trends also suggest that these funds will get significantly bigger – similar to their existing US counterparts.
So, what are the key features of these funds that managers should focus on in order to maintain or secure competitive advantage in this high growth and highly competitive space?
Much of the industry conversation in relation to open end core funds over the last 12 months has focused on pricing mechanisms. EY and several other organizations have been at the fore of this conversation. However, whilst the manner in which units in these funds are priced for the purposes of subscriptions and redemptions is undoubtedly a very important matter, few managers have cited this as a key consideration of existing and target investors they deal with. Improved investor understanding on this topic would certainly be welcome in the industry so too would formalized best practices in relation to the governance and transparency models that accompany these mechanisms. Thankfully, this appears to be the direction of travel of industry groups.
The design features of these funds which seem more likely to generate interest from investor groups are varied but include the fund investment strategy, the fund structure, liquidity feature, fee arrangements and investor reporting.
Fund investment strategy is, unsurprisingly, key. No factor contributes to a manager’s success in capital raising more directly than their proven track record in a specific market segment. As challenges in capital deployment increase due to increased property market activity managers will come under pressure to demonstrate their ability to find alternative investment targets whilst not falling into the trap of strategic drift.
The European and Global regulatory agenda, amongst other factors, has caused the chosen structure and geographical jurisdiction of a fund to become a more relevant determinant of their success in capital raising than ever before. The post- AIFMD environment means that intelligently implementing new regulation into a manager’s global operating model is key to ensuring access to capital markets. Overlaying this complex regulatory agenda is the ever evolving tax environment. Establishing and maintaining tax compliant structures is a major focus of all managers currently. In addition, investors are becoming more sensitive to this agenda and performing enhanced diligence to ensure that the tax structure and compliance monitoring process does not expose their investment or their reputation to unacceptable levels of risk.
One of the main differentiation factors of an open end real estate fund versus its close end cousin is that it provides the investors with a measure of liquidity. The process through which the manager balances the provision of this liquidity with the inherently illiquid nature of the underlying asset class has always been a lively talking point. The challenge which the manager must respond to here is providing liquidity to investors who request it while not compromising potential for value creation and the interests of all investors collectively.
Fee arrangements are also the subject of regular discussion and can prove to be a factor which influences an investor’s choice of manager. The ultimate challenge is to ensure that the fee arrangements in place promote alignment of interest. However, real estate as an asset class does not exist in isolation from other asset classes and must respond to the growing downward pressure on fee levels. A notable difference in market practice has historically been observed between funds managed by traditional asset managers and those managed by private equity firms. While traditional managers have favored the use of an all in management fee based predominantly on NAV, PERE firms have generally had more granular fee arrangements which charge separately for items such as acquisitions, disposals, leasing etc. The general trend overall is to have simple and understandable arrangements. The challenges which managers face here are to respond to the downward pressure on fees prevalent in the market and to demonstrate the value of their management services.
Investor reporting is also becoming a far more sophisticates and holistic process. Investors KPIs are no longer purely financial and they are keen to be provided with information a wide range of topics that impact the reputational and financial risk of their investments. Managers are responding to this by developing more integrated reporting systems across their platform which allow them to respond to these investor demands but also utilize their data in more valuable ways.
Overall, the future for open end core funds seems bright. However, it is likely that this capital raising will be focused on a small number of market participants and there are clear challenges to face in order to be amongst this successful few. The pursuit of competitive advantage in this area will inevitably lead to innovation right across the European real estate funds market and should ultimately provide robust investment products capable of producing strong and sustainable investor outcomes.