Real Estate Fund Management: Non-Listed Funds and the Risk-Reward Space

Contents

Introduction

Non-listed real estate funds and the risk-reward space

Classification of non-listed real estate funds: AREF and INREV

Non-listed real estate fund performance and INREV style classification

Drivers of property fund risk and returns

Conclusion

Works Cited

Introduction

This essay examines the ability of investors to take desired positions in the risk-reward space by building a portfolio of non-listed funds of different investment styles. The question is examined from the viewpoint of a major institutional investor not subject to meaningful capital constraints. While it is acknowledged that there might be significant practical barriers when implementing the desired portfolio strategy, the essay focuses on the basic theoretical viability. The latest research on non-listed property fund performance was drawn upon. Furthermore, data from the Association of Real Estate Funds (AREV), the European Association for Investors in Non-Listed Real Estate Vehicles (INREV) and the Investment Property Databank (IPD) was used for illustrative purposes. To begin with, a brief introduction to non-listed funds and the concept of risk and reward is given. Subsequently, the methodologies applied by AREF and INREV to classify non-listed property funds are illustrated. Thereafter, the historic performance achieved by different styles is discussed. Then, factors determining the INREV style classifications are compared with the performance drivers identified by recent research. The findings are summarized in the last section.

Non-listed real estate funds and the risk-reward space

A non-listed real estate fund is a vehicle, run by a fund manager, which pools the capital of three or more investors in order to undertake real estate investments (INREV, 2012a, p. 6). Funds with a predetermined life, usually 6-10 years, are called closed-ended funds. Open-ended funds do not have a fixed termination date and are designed to allow more flexible investments and redemptions (Baum & Hartzell, 2012, pp. 295 ff.).

illustration not visible in this excerpt

Source: Geltner at al., 2007, p. 187

Investors in non-listed property funds will consider the risk and return characteristics of the funds when allocating their capital. Basic financial theory states that expected returns should be greater for more risky assets. This can be described as where is the return on a riskless security and the expected ex ante risk premium. The risk premium depends on the risk perceived by the investor (Geltner, et al., 2007, pp. 186 ff.). Open-ended funds dominate the lower end of the risk-reward spectrum whereas closed-ended funds tend to aim at the higher end (Baum & Hartzell, 2012, pp. 195 f.).

Investors usually hold a portfolio of assets. Hence, the strength of association of asset returns, i.e. their correlation, becomes an important component in determining the portfolio risk and return position (Brown & Matysiak, 2000, pp. 249 ff.). Modern portfolio theory offers a framework to compute and optimize expected portfolio risk and return. While its applicability in a property context is seriously questioned (Sirmans & Worzala, 2003, p. 1090), it is important to acknowledge that the total risk of a portfolio is usually different from the weighted standard deviation of its assets. To assist investors with investment decisions and portfolio allocation it can be useful to classify funds in distinct categories (Lee, 2008, p. 3). The following section will describe the methodology used by AREF and INREV to classify non-listed real estate funds.

Classification of non-listed real estate funds: AREF and INREV

AREF, in cooperation with IPD, currently covers 67 UK property funds with a gross asset value (GAV) of GBP 44.7 bn. At the most basic level AREF distinguishes balanced, long income and specialist funds (IPDa, 2013, p. 5). The table below shows the definition of the fund categorization.

illustration not visible in this excerpt

Source: IPD, 2013a, pp. 434 ff., own table

The chart below shows the average annual returns achieved and standard deviation revealed by balanced and specialist funds between 2002 and 2013. Long-income funds were not considered as for this class only one observation is available. According to IPD (2013a, p. 11) balanced funds on average achieved lower returns (5.70% p.a.) and were subject to a lower standard deviation (13.33% p.a.) compared to specialist funds (return 7.32% p.a., standard deviation 20.03% p.a.). The revealed relationships are in compliance with the risk and return trade-off explained above.

illustration not visible in this excerpt Source: IPD, 2013a, p. 11 and own calculations and chart

In order to cluster funds with similar risk and return characteristics INREV classifies funds by investment styles. The first framework was developed in 2004 with target levels of internal rate of return (IRR) and leverage as the determinants of style. This model proved not workable as target IRRs and leverage change with market conditions. INREV published its new framework in 2011. It is based on the idea that style is determined by the ‘bundle of risks’ that the fund is exposed to. Instead of levels of risk and return over time, the variation in returns over time should define the style a fund. The style classification should help investors to distinguish different investment strategies and to communicate with the fund managers (INREV, 2011, p. 5). The table below shows the descriptive style analysis of the three INREV styles.

illustration not visible in this excerpt

Source: INREV, 2011, p. 7, own table

By means of statistical analysis, leverage, development exposure and the level of non-income producing investments were found to be the relevant factors to allocate funds to the low, medium or high risk category. Investments in non-income producing assets, exposure to (re)development risk and strategies focusing on capital appreciation are regarded as more risky than investments in income producing assets and focus on income return. Additionally, risk is assumed to increase with leverage (INREV, 2011, pp. 10 f.). The framework was subsequently revised and an updated version which introduced the distinction between lower than 40% and greater than 40% loan-to-value (LTV) core funds was published in February 2012 (INREV, 2012b, p. 13). The table below shows the allocation in accordance with the amended framework.

[...]