August 2007

PROPERTY HEDGE FUNDS: Turning over a new leaf

With property yields at new lows, investors are turning to hedge funds, which exploit the weakened market, writes Kristen Paech 07_08_hedge_fundsThe real estate industry has earned a reputation as a stable, high yielding asset class and a good diversifier from traditional assets such as equities and bonds. Insatiable demand over the past three years drove UK commercial property share prices ever higher while fund managers sat back and watched profits soar. Now, however, with property yields at new lows, many investors are less bullish about the outlook for the market. UK commercial property delivered a four-year low of 2.5% in the first quarter, according to Investment Property Databank (IPD) figures, and the prospect of matching the 2006 return of 17.9% seems like a pipe dream. The beauty of hedge funds though, is that this is irrelevant. Their ability to extract alpha from markets regardless of whether they are rising or falling means they should thrive at times when other investors falter. Accordingly, a number of fund management houses are launching property hedge funds which aim to exploit this weakened market sentiment and volatility by using it to their advantage. New Star announced in July that it had recruited Robin White, manager of the Rock Real Estate Securities fund, to manage a hedge fund that will invest predominantly in property securities. The fund is expected to be launched in the last quarter of 2007. Specialist manager Reech AiM and property advisory firm CB Richard Ellis have also joined forces to enter the property hedge fund arena, creating Reech CBRE Alternative Real Estate – an alternative investment management company that plans to develop six property hedge funds over the next two years. The first – Iceberg Alternative Real Estate fund – is expected to raise £400m (e590m). It will invest across the entire spectrum, targeting listed and unlisted securities and property derivatives in the UK and Europe. “We are going to take advantage of the fact that there is this uncertainty in the market to offer returns and risk to investors which are more in line with what they think about the market compared to the long-only funds which are only taking the beta out of the market,” says Christophe Reech, chief executive of the 50:50 joint venture. “We are offering our investors a risk and return profile which is neutral to the real estate market and gives them, if not a hedge, at least a very good source of pure alpha without taking the trend of the real estate market.” Such vehicles will largely attract institutional investors, and indeed that is who they are targeting. However, given their non-directional nature they could also appeal to high-net-worth individuals or family office investors. The contenders
Reech CBRE Alternative Real Estate and New Star join a handful of established US-based property hedge funds which are able to go either long or short in property shares. Alpha Equity Management, Woodbourne Investment Management and JMP Asset Management entered the fray in the early 2000s with a variety of strategies that range from offsetting long and short positions in equity real estate investment trusts (REITs) to investing in securities that are less correlated to the major stock market indices. However, interest in this small but growing market is gathering pace. Phelan Capital, Mercury Real Estate Advisors, Third Avenue Management, RREEF American and Envision Capital Management all launched property hedge funds last year, while ORN Capital, a hedge fund backed by Morley, in March launched the first fund of property derivatives that has no physical exposure to bricks and mortar. Furthermore, Absolute Capital Management, Sarasin, Kempen and Fortis Bank are all said to be drawing up plans for property hedge funds. A major driver behind the building interest is the development of the IPD swap market, according to Taco Sieburgh, head of research at hedge fund consultancy Liability Solutions. A series of derivatives contracts, each linked to the IPD UK Annual Index rates of total return, capital growth and income growth, were agreed in January 2005. The development means investors are now able to increase or decrease their exposure to UK property returns by ‘buying’ or ‘selling’ contracts which deliver the cash returns reflected in the movements of the index over given time periods. “Opportunities in the IPD market are such that for the first time, shorting is a viable option,” Sieburgh explains. “That will lead to two things: the very largest hedge funds will have traders going into these areas as an add-on to what they’re doing, and secondly you will see more hedge funds being launched on this market. People are looking not for hedge funds taking property exposure, but to see where the relevant mispricings are in the property space.” David Hunter, managing director at property fund consultants Hunter Advisers, believes the emergence of property hedge funds is simply an extension of an established practice within property fund management. “Short term holding of property stocks is perfectly valid,” he says. “People have been doing it one way or another for years but there’s no reason why the hedge funds shouldn’t do it on a more formal, organised basis. We are seeing increasing use of derivatives and in a way, launching property hedge funds is consistent with a more streetwise approach to the property market. Many years ago you simply bought and sold a building – now people are realising that property is a financial instrument that can have financial products built around it.” Moving in tandem
At a time when hedge funds are training their eyes on property market volatility, the shaky ground on which real estate fund managers are standing has sparked a rethink over the tools at their disposal. Conventional property fund managers have begun using property derivatives as a way of securing returns in a less certain environment, meaning hedge funds and traditional property funds are seemingly shifting in the same direction. “I wouldn’t call it a clash, it’s more of a transformation,” says Sieburgh. “The demarcation between property funds and hedge funds could become less clear cut.” Olivier Cassin, director, head of product development and research at bfinance, says some clients are seeking value added funds as opposed to core or core plus, including a high level of leverage. “We have also seen managers using derivatives to get a tactical exposure to a particular market or sector,” he adds. ING Real Estate Select is one of these managers. Nick Cooper, chief executive officer, says because the firm’s funds are designed to be long in real estate, synthetics are used where the underlying exposure to target markets cannot otherwise be obtained. He agrees the distinction between sectors is blurring, yet he believes that the difference comes in what the two managers are setting out to achieve. “Where the two lines blur is at the very margins, because the long real estate manager might use a derivative to short his position,” Cooper says. “But ultimately the real estate manager is using the derivative as a thought process because his portfolio is designed to be long in real estate, whereas the hedge fund manager will be purely driven by performance.” In addition, there are marked differences between how the different funds operate. Reech says: “There is a difference between a real estate derivatives fund and a fund which is using financial instruments including real estate derivatives. We think real estate derivatives are, as every derivative is, an instrument that you use as a tool. It is not the sole purpose of our fund.” Overcoming barriers
For those firms moving into this space the ability to find success is not without challenges. As with any area of investment management, execution is key. There’s also a mark to market risk – while any rapidly growing yet illiquid market has mispricings, there is no way of telling how long those distortions will remain. Ravi Anand, head of structured products at New Star, says it is difficult to use shorting to make short term gain from property market movements. “If one is just going short because of a view that office markets are going to go down in the next six months, that’s quite a difficult call to make because property markets don’t move that quickly, they move over time,” he explains. “If one is shorting to hedge something else, for example you are long on London retail properties and short on offices, then as a joint trade, long and short, you can make money. But timing property markets in individual subsets of property markets can be difficult and is not a short term gain to be made.” Being a nascent market, there are also not as many sellers of derivatives contracts as investors would like, making trading more difficult, although this is changing. The fact that there are more and more prospective ‘buyers’ means it is seemingly only a matter of time before the market gains depth. Hunter says: “One of my clients with a big pension fund portfolio has concerns about future property performance but doesn’t want to sell the portfolio so the answer for that client is to sell a derivative. That’s becoming accepted currency in the property investment industry. It may be part of the armoury of the hedge funds, but it’s not exclusive armoury and it is part of the cavalry of big investors as well now.” © fe August 2007

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