the real estate funds

Giuseppe Merenda

January 2012

The Real Estate Funds Giuseppe Merenda "1

The Real Estate FundsSHORT GUIDE TO PROFESSIONAL REAL ESTATE INVESTMENT

Introduction The importance of real estate funds has been growing dramatically in recent years.

Since year 2000, RE funds continued to expand in terms of their number and average size.

Although several high-profile takeovers of large publicly-traded real estate entities have underscored the influence of RE funds, relatively little is known about them. Questions which have arisen regarding such funds include: what are RE funds and what distinguishes them from other types of real estate investment vehicles? Why have they attracted so much investment capital? And, what are their prospects in a post credit crunch environment? These are among the issues we address in this paper.

Investors have been adopting increasingly active management approaches to real estate investing and portfolio management. It was not that long ago such investors viewed the need for industry-specific experience, specialised skills, and local market knowledge as impediments to real estate investing. Today, they view such attributes (either in-house or procured externally) as opportunities to:

(a)expand into new markets;

(b)diversify their holdings and;

(c) enhance overall investment returns.

This change is particularly evident amongst the largest North American and Canadian pension funds, most of which have substantial exposure to RE funds. In general, their commitment to RE funds reflects an appreciation of the role that management plays in the performance of real estate portfolios. This role consists of two parts: (a) identifying investment trends and opportunities at a macro level, and (b) implementing corresponding investment strategies at a micro level. Management in this context can be defined as human capital, which possesses the creative vision, motivation and expertise, to conceive and successfully execute investment strategies.


Real Estate Funds Like mutual funds, real estate funds are founded by a group of real estate professionals to 'manage' property/real estate for the investor.

The real estate fund is a publicly listed, or private entity, which typically own large commercial office spaces, shopping malls, hotels and rely mainly on rental incomes. However, there are some that are more focused on capital appreciation as well.

Real estate funds buy, develop and sell property and share profits with investors/unit-holders from any capital appreciation on the sale of property. Apart from sale of property, real estate funds also make money from rentals on property owned by them.

Some real estate funds may not actually own property as that may involve above-average risk from volatility in property prices. Instead such funds invest in bonds/instruments that are secured by property. The coupon rate that they receive on these bonds/instruments is then distributed to investors/unit-holders as dividends.

Needless to say, this expertise comes at a cost to the investor. Real estate funds like regular mutual funds charge fund management fees, brokerage fees (for buying and selling property), administration fees, marketing fees and the like. So investors clock a return on real estate fund units only after accounting for fees and charges.

There are different real estate funds structures. The most important are:

Real Estate Investment Trust (REITs)

Private Equity Real Estate (PERE)

Open-end or Close-end Real Estate Fund

Real Estate Investment Trusts - REITs REITs allow small investors to share in the many benefits associated with real estate while reducing the overall risks that accompany property ownership.

REITs are an efficient way for many investors to invest in the commercial real estate business. In general, a REIT is a company that combines the capital of many investors to acquire or produce financing for real estate


Many investors know that the benefits of owning real estate include current income or the potential for capital gain. They also understand that direct investment in real estate often requires large amounts of initial capital, uncertain property operating expenses, as well as the time and expertise to properly manage real estate properties. Additionally, the cyclical nature of real estate can make such investments difficult to sell.

One alternative to direct ownership of real estate is an investment in a Real Estate Investment Trust (REIT). REITs allow small investors to share in the many benefits associated with real estate while reducing the overall risks that accompany property ownership.

REITs bring together capital from many individuals specifically to invest in a diversified portfolio of income-generating real estate, or in real estate-related debt (mortgages). Individuals invest in a REIT by purchasing shares, similar to shares of common stock. The shares of many REITs are publicly traded on major stock exchanges or over-the- counter markets.

If a REIT is profitable, shareholders can receive dividend income (from rental income), and capital gains from the sale of real estate assets. Some REITs specialise in a single type of commercial property or region of the country. Other REITs diversify their investments over various types of properties or in different geographic areas.

REITs are an efficient way for many investors to invest in the commercial real estate business. In general, a REIT is a company that combines the capital of many investors to acquire or produce financing for real estate. A REIT offers the benefits of a diversified real estate portfolio under professional management. In addition, a REIT must pay distributions to investors of at least 90% of its taxable income.

For real estate mutual fund managers, every region represents a unique investment environment. The Australian and North American REIT markets, for example, are very mature.

Australian fund managers must specifically distinguish between the management of wholesale and retail funds, which are expected to be distinctly different due to the targeted investment community.

The managers of European real estate mutual funds are faced with a vast number of country specific REIT-like structures that differ in terms of legal and tax standards, but also in terms of financing, managerial freedom, and focus.


In Asia, different REIT-like structures are also emerging, but the property share market is still dominated by development companies, which complicates a manager’s stock-picking process.

Global real estate mutual fund managers must take all of the above into account. However, there are two major advantages to a globally focused investment approach, and both stem from the fact that a much larger universe of property stocks is available when investing globally.

I. A high degree of portfolio diversification can be achieved, thus reducing risk given the same expected return. This follows from the relatively low expected correlations in returns across geographical areas.

II. The potential for higher overall excess returns is increased by investment in real estate markets with different levels of economic growth.

REITs Investment Sectors With a very diverse profile, the REIT industry offers investors many alternatives across a broad range of specific real estate property sectors, including:

• Apartment communities • Office properties • Shopping centers • Regional malls • Storage centers

• Industrial parks and warehouses • Lodging facilities, including • hotels and resorts • Health care facilities • Natural resources

Following the lead of the United States, many countries around the world have established REIT regimes during the last 40-plus years. The same attributes that have driven the growth of REITs in the U.S. - diversification, dividends, transparency, liquidity and performance - are fuelling the growth of publicly traded real estate throughout the world.

Countries that have adopted REIT-like structures range from established financial environments, such as the United Kingdom and Japan, to emerging markets like Taiwan and Malaysia. The most comprehensive index for the REIT and global listed property


(source:NAREIT)

market is the FTSE EPRA/NAREIT Global Real Estate Index Series, which was created jointly by the index provider FTSE Group, NAREIT and the European Public Real Estate Association (EPRA). The index is used by a variety of institutional investors, money managers and funds to manage real estate investment on a global basis. The Global Index Series contains the Developed Markets indices and the Emerging Markets indices (launched in January 2009).

At the end of September 2011, the FTSE EPRA/NAREIT Developed Market Real Estate Index consisted of 288 companies spread across 19 countries, with a total market capitalisation of $868 billion. The FTSE EPRA/NAREIT Emerging Markets indices provides investors with a diverse representation of more than 100 publicly traded equity REITs and listed property companies with aggregate market capitalisation of nearly $90 billion from 13 emerging markets across the Americas, Europe, the Middle East, Africa and Asia.


Global REIT Chronology - Countries with Existing REIT-Like Structures

!

(source:NAREIT)

FTSE EPRA/NAREIT Global Real Estate Index Series

! (source: NAREIT)


PERE - Private Equity and Real Estate As the name implies, private equity real estate is a hybrid of the “private equity” and “real estate” asset classes. In general, private equity investments encompass various forms of strategies for investing in businesses or stand alone assets, where ownership is neither widely-held nor traded on public stock exchanges.

While traditional private equity consists of direct ownership by investors, private equity funds relate to indirect ownership by investors through a third-party fund manager. In most cases, the investors themselves are private entities (i.e. pension funds).

Aside from real estate oriented-funds, types of private equity funds include those which invest in privately-held companies with growth potential (i.e. venture capital funds), and those taking mature public companies private (i.e. leveraged buyout, or “LBO” funds), among others.

Many funds employ leverage as a means to enhance returns but leverage is typically not the exclusive investment strategy, if used at all (i.e. venture capital investments are not able to obtain financing during early stages of growth). Leverage should be viewed as a way to improve returns on an already good investment strategy.

Not to be confused with hedge funds, private equity funds typically invest with the intent of owning and managing their investments for several years or more. The primary objective of private equity funds is to create or enhance value through “hands-on” management at the operational level.

Private equity is attracted to real estate because many of its inherent attributes fit well with strategies employed by most private equity firms. This may in part explain why PERE funds have grown from being a niche sector within the private equity asset class, to being second only to LBO funds in terms of capital raised over recent years.

Such attributes include:

Ownership and Control Direct ownership allows for greater control over the direction and destiny of investments. While the discretion on a publicly-traded security is limited to “when to buy” and “when to sell”, direct ownership adds “management” to this equation. Active management allows owners of investments to pursue strategies which can improve returns beyond those achieved as a result of general market forces, at both the asset and entity level.


Wealth Creation In certain circumstances, real estate assets present opportunities for knowledgeable managers to add value by improving the physical, financial, and/or operational characteristics of a property. Value-add strategies, if successfully executed, can yield a property value which is substantially higher than the sum of the acquisition cost and additional capital invested, within a relatively short period of time. Generally value-add strategies involve turning underperforming or non-institutional quality assets into stable, cash flowing, institutional quality assets.

Sub-dividable Interests Real estate interests can be subdivided in a multitude of ways. For example, whole portfolios can be bought and sold individually or in any combination of clusters (i.e. by geographic location or property type). Individual properties may be subdivided, financed, and/or leased. The success of these strategies lies in a fund manager’s ability to identify which assets, structures, and potential buyers, when combined, yield the highest aggregate value. Compared to other types of non asset-based investments (i.e. those which have a strong reliance on brand equity, goodwill, trademarks, among other intangible assets), real estate can be broken-up into separate pieces more easily, with each component potentially more valuable than before.

Platform Value Just as assets can be subdivided easily, they can also be combined to create more profitable portfolios. Recognizing that real estate is management-intensive, and that different market segments require different skill sets, PERE funds have evolved their strategies to place an increased focus on the value of operating platforms. Building or acquiring an operating platform and using the economies of scale that it provides, allows accretive acquisitions of assets and/or development of new assets.

Financeability Because of real estate’s inherent characteristic as a stable and predictable generator of cash flow, it is financeable on more favorable terms than other types of transactions. For example, most recent non-real estate LBOs have been able to obtain debt levels ranging between 6-8x debt multiples (i.e. debt divided by cash flow). However, it is not uncommon for many types of real estate transactions (buyouts or otherwise) to obtain debt multiples in the 10-12x range. Even though its


cash flow may be “lumpy” at times, real estate is highly financeable because it is tangible. As such, it serves as excellent collateral which lenders are able to underwrite to relatively higher debt levels, longer terms, and lower costs of capital.

Dual Market Liquidity Real estate has the advantage of being tradable in both public and private markets. In certain circumstances this provides PERE funds an opportunity to arbitrage between the two markets by taking undervalued public companies private. These parallel markets also provide PERE funds two separate exit strategies:

(a)selling assets to the private market or

(b)converting an accumulated portfolio of assets into a public entity via an initial public offering (“IPO”)


Type of Pr ivate Equi ty Real Estate Funds

Type of FundTarget

Net IRRs Typical Characteristics

Core 7-9%

• Well-diversified, low risk/return strategy • Traditional asset classes (i.e. office, retail, industrial, multi-family) in

established locations • Well occupied and well maintained assets with stable cash flows • Generally little or no debt is employed (i.e. up to 30% levered) • Income stream represents significant part of expected total return

Core-Plus 9-12%

• Moderate risk/return strategy • Core-type assets, some of which may require some form of value-add

enhancement • Assets located in either primary or secondary locations • Moderate amount of leverage employed (i.e. up to 55% levered)

Mezzanine Lending /

Distressed Debt

9-12%

• Originate loans at terms which are more aggressive than traditional lenders

• May contain profit-sharing in addition to higher interest rates and fees charged

• Acquire distressed loans from lenders at discount prices (i.e. below par value)

• Participate in higher-yielding tranches of mortgages (i.e. non-rated CMBS; first-loss positions)

• Generally not averse to owning the assets in the event such loans de-fault

Value-Add 12-16%

• Moderate-to-high risk/return strategy • Opportunity to add value through operating, re-leasing, and/or re- de-

velopment • Leverage employed is higher (i.e. up to 70% levered) • Value appreciation comprises significant part of expected total return

Fund-of- Funds 12-16%

• Funds which invest in a number of third-party managed PERE funds • Aggregate capital of smaller investors and invest such capital on their

behalf • Provide smaller investors access to larger, more exclusive PERE

funds • Offer a diversified investment strategy through a single channel

Opportunistic >16%

• High risk/return strategy • Re-positioning of poorly managed, obsolete, and/or vacant assets • Acquisitions of entire companies with portfolios of assets and operat-

ing platforms in-place • New-build development or conversion projects • International focus pursing opportunities in established and emerging

markets • Leverage employed is higher (i.e. over 70% levered)


Open-end and Closed-end Funds

Open-end fund An open-end fund is equitably divided into shares which vary in price in direct proportion to the variation in value of the fund's net asset value. Each time money is invested, new shares or units are created to match the prevailing share price; each time shares are redeemed, the assets sold match the prevailing share price. In this way there is no supply or demand created for shares and they remain a direct reflection of the underlying assets.

Closed-end fund A closed-end fund issues a limited number of shares (or units) in an initial public offering (or IPO). The shares are then traded on an exchange or directly through the fund manager to create a secondary market subject to market forces. If demand for the shares is high, they may trade at a premium to net asset value. If demand is low they may trade at a discount to net asset value. Further share (or unit) offerings may be made by the scheme if demand is high although this may affect the share price.

The added element of market forces tends to amplify the performance of the fund increasing investment risk through increased volatility.

Open-end Real Estate Funds Open-end real estate funds are indirect real estate investment vehicles that are of particular importance in Europe, mainly in Germany.

Shares are directly backed by the properties and liquid assets held by the fund. In contrast to a closed fund structure, an open-end investment fund continuously creates new shares on demand.

Investors can buy shares at net asset value from the fund and may redeem them on a daily basis at the prevailing net asset value, which can be higher or lower than the initial price at which the investors bought.

Consequently, even though shares are typically not traded on a secondary market, they are a liquid investment.

The price is quoted based on the regular valuations of the properties and liquid assets at that time.


Since the regular valuations are typically done only once a year on a rolling basis for each property, the redemption value of a fund’s shares adjusts slowly to changes in the market price of the underlying properties.

Closed-end Real Estate Funds Closed-end real estate fund is a collective investment scheme with a limited number of shares.

New shares are rarely issued after the fund is launched; shares are not normally redeemable for cash or securities until the fund liquidates. Typically an investor can acquire shares in a closed-end fund by buying shares on a secondary market from a broker, market maker, or other investor as opposed to an open-end fund where all transactions eventually involve the fund company creating new shares on the fly (in exchange for either cash or securities) or redeeming shares (for cash or securities).

The price of a share in a closed-end fund is determined partially by the value of the investments in the fund, and partially by the premium (or discount) placed on it by the market. The total value of all the securities in the fund divided by the number of shares in the fund is called the net asset value (NAV) per share. The market price of a fund share is often higher or lower than the per share NAV: when the fund's share price is higher than per share NAV it is said to be selling at a premium; when it is lower, at a discount to the per share NAV.

In the U.S. legally they are called closed-end companies and form one of three SEC recognised types of investment companies along with mutual funds and unit investment trusts. Other examples of closed-ended funds are investment trusts in the UK and listed investment companies in Australia.

Some characteristics that distinguish a closed-end fund from an ordinary open-end mutual fund are that:

1. it is closed to new capital after it begins operating, and

2. its shares (typically) trade on stock exchanges rather than being redeemed directly by the fund.

3. its shares can therefore be traded during the market day at any time. An open-end fund can usually be traded only at the closing price at the end of the market day.


4. a CEF usually has a premium or discount. An open-end fund sells at its NAV (except for sales charges).

Another distinguishing feature of a closed-end fund is the common use of leverage or gearing to enhance returns. CEFs can raise additional investment capital by issuing auction rate securities, preferred shares, long-term debt, and/or reverse-repurchase agreements. In doing so, the fund hopes to earn a higher return with this excess invested capital.

When a fund leverages through the issuance of preferred stock, two types of shareholders are created: preferred stock shareholders and common stock shareholders.

Preferred stock shareholders benefit from expenses based on the total managed assets of the fund. Total managed assets include both the assets attributable to the purchase of stock by common shareholders and those attributable to the purchase of stock by preferred shareholders.

The expenses charged to the common shareholder are based on the common assets of the fund, rather than the total managed assets of the fund. The common shareholder's returns are reduced more significantly than those of the preferred shareholders due to the expenses being spread among a smaller asset base.

For the most part, closed-end fund companies report expenses ratios based on the fund's common assets only. However, the contractual management fees charged to the closed-end funds may be based on the common asset base or the total managed asset base.

The entry into long-term debt arrangements and reverse-repurchase agreements are two additional ways to raise additional capital for the fund. Funds may use a combination of leveraging tactics or each individually. However, it is more common that the fund will use only one leveraging technique.

Since closed-end funds are traded like stock, a customer trading them will pay a brokerage commission similar to one paid when trading stock (as opposed to commissions on open-ended mutual funds where the commission will vary based on the share class chosen and the method of purchasing the fund). In other words, closed-end funds typically do not have sales-based share classes where the commission and annual fees vary between them. The main exception is loan-participation funds.


Definitions of Terms Main terms used in Real Estate Funds are as follows:

Fund Type

Fixed property type A type of fund in which the properties to be acquired are identified before the establishment of the relevant fund

Additional acquisition type A type of fund in which although certain properties to be acquired are identified before the establishment of the fund, additional properties are acquired after the establishment of the fund

Discretionary acquisition type A type of funds in which the properties to be acquired are not identified before the establishment of the relevant fund, and properties are acquired at the discretion of a manager in accordance with predetermined transaction policies and standards; Also called a blind pool type

Management Style

Core An investment style in which stable long-term investments are made by investing in sound properties to primarily obtain income gains and capital gains

Opportunity An investment style in which investments are made in relatively unprofitable properties, and after addressing issues and improving the value of the properties, they are sold to achieve capital gains; Opportunity also includes funds that partially invest in development-type projects and corporations.

Value-added An investment style that lies between Core and Opportunity, and aims to achieve both income gains.

LTV Loan To Value The Loan to Value (LTV) is the ratio of borrowings against the asset value. In practice, there are cases in which the acquisition value of properties is used as the asset value, and the total investment value is used as the asset value. If the total investment value is adopted, usually the total investment value is adjusted to the


value based on the property acquisition value by using the ratio of expenses other than acquisition expenses against the total investment value calculated from the average of general examples.

Real Estate Investment Vehicles Chart


Real Estate Investment

Direct Investment

Indirect Investment

Listed

Property Stocks

REITs

Fund of Funds

Non Listed

REITs PERE Open-end

Funds

Mutual Fund

Property Stocks

Closed-end Fund

Joint Ventures

Partnership

Syndication

Property Stocks

the real estate funds

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