Good financial modelling of real estate funds means investors can ensure they are achieving their objectives, say Michael Hornsby, Nicolas Gillet, and Nicolas Bolland, of Ernst & Young's Luxembourg practice.
The recent credit crunch and slow subsequent economic recovery have highlighted the increasing need for effective back- and middle-office monitoring processes within real estate funds in order to improve their overall management efficiency, risk management and compliance functions.
Examples of the pressure on these funds include the stricter enforcement by tax authorities of the transfer pricing and “thin capitalisation” rules. The transfer-pricing rule relates to OECD guidelines on intragroup transactions, which must be carried out at “arm’s length” to avoid tax evasion, and the thin capitalisation rule relates to the requirement of some tax authorities for a minimum capitalisation of special purpose vehicles.
In addition, future regulation (for example, the Alternative Investment Fund Managers Directive - or AIFM - and Solvency II) will require more sophisticated and accurate modelling of liquidity and risk sensitivities.
A key element of a real estate fund’s monitoring process is its financial or cash-flow modelling – but what does this entail and how useful can it be in practice?
In this context, a sound, generic knowledge of modelling techniques is invaluable. A high-quality financial model should have a robust structure allowing for safe, trackable changes throughout its life. It should also contain embedded integrity checks as well as flexibility to allow for sensitivity analysis on the major inputs and scenarios. A robust, flexible, customised and easy-to-use financial model provides an efficient day-to-day management and compliance tool, as well as supporting management’s analysis of key investment decisions.
A meaningful comparison
Depressed overall returns during the past three years, volatile real estate asset values and increasing risk management concerns have lead investors to request additional qualitative and quantitative performance and risk information from fund promoters, often in a highly customised format.
This is also consistent with the development of industry guidelines for both the listed and unlisted sectors in respect of standardised historical and forward-looking performance metrics. This facilitates benchmarking with other asset classes and, crucially, allows more meaningful comparability of the performance of different real estate funds.
The embedding of appropriate functionality within the design of a fund’s financial model will allow the effective benchmarking and management of fund expenses and, in particular, facilitate the routine calculation of key metrics – both historical and forward-looking – such as the total expense ratio, real estate expense ratio and return reduction metric, as recommended by Inrev, the association for European investors in non-listed real estate.
Using both actual and estimated forecast metrics allows investors to see how closely a fund tracks its objectives and to follow management’s analysis and explanations regarding performance.
Tax planning is another area where budgeting, and hence modelling, is of paramount importance. In particular, predicting trapped cash within a fund structure is a critical issue as it directly impacts income yields and overall fund returns.
If trapped cash can be predicted early enough, appropriate measures can be taken to mitigate its adverse consequences.
An appropriately sophisticated model can be also be used to monitor other tax risks such as thin capitalisation requirements, transfer pricing rules and other relevant structuring matters.
Additionally, a flexible financial model is a potentially powerful risk management tool as it allows management to carry out sensitivity and scenario analysis in order to measure the impact of changes in major variables such as interest rates, foreign exchange rates, yields and letting assumptions on performance measures and financing covenants.
A well-designed model should provide both a sound picture of how resilient the current structure is in the event of adverse changes in the above variables, and also reveal areas of potential improvement – refinancing, hedging, etc – indicated by the results.
On a shorter-term perspective, the model can be used as a day-to-day tool to manage liquidity risk and ensure ongoing compliance with covenants such as loan-to-value ratios or interest coverage ratios.
Support for decision-makers
A model may be used not only in the context of ongoing operational activities but also to provide valuable insight and support for decision-makers in the context of transactions such as acquisitions, disposals and letting.
A sound financial model can also aid management in negotiations regarding the structuring of new finance, especially if sensitivity analysis can be carried out to highlight risks related in respect of covenants or provide assurance to counterparties. Transactions such as sale and leaseback arrangements or vendor due diligence related to the sale of portfolio assets also benefit from a well-designed model.
In conclusion, as the real estate industry has moved through the end of the last economic cycle, the importance and benefits of robust financial models has been recognised.
A robust and flexible financial model has multiple outputs and users spanning front, middle and back-office functions. This supports investor reporting, risk and liquidity management, transactions and tax operations.
It is the right time for asset managers to assess their capabilities in this area before we move into the next economic cycle
• Michael Hornsby is real estate leader; Nicolas Gillet is partner, valuation and business modeling services; and Nicolas Bolland is senior manager, valuation and business modelling services, at Ernst & Young
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