July-August 2011


Beach-shedsSmaller pension funds could learn a lot from larger plans when it comes to taking control of commercial property investments. Senior executives talk to Angele Spiteri Paris about the new rules of engagement.
Institutions currently hold most of the good cards when it comes to investment in commercial property. That is because they hold precious capital which investment managers need to get their hands on. Aware of this, and disappointed by the damaging effect of leverage and poor communications in the recent past, institutional investors are now more exacting in their expectations. Although some issues around fees still exist, institutional investors are largely getting what they want. The IPD index for UK commercial property dropped a whopping 22.1% in 2008. The Eurozone was not as badly hit and remained in positive territory, returning 1.2% in 2008 and 0.2% in 2009. Despite these figures, unlisted real estate was found to be resilient, if illiquid. According to ING Real Estate Investment Management, it outperformed every other major investment asset class, with the exception of bonds, in the financial crisis. Most large institutions held on to their portfolios during the tough period, sticking to their strategic view that real estate is a ­good diversifier. Michael Nielsen, managing director at ATP Real Estate Partners, part of ATP, Denmark’s largest pension scheme which has around DKK500bn (€67bn) in assets under management (AuM), says: “Overall, the crisis has not changed our approach to real estate. We still consider it an attractive alternative asset class that can help hedge inflation risk.” What has changed for Nielsen and his contemporaries is that there is a greater focus on due diligence when preparing to invest. “We learnt our lessons from the crisis and we now ask for more detail. We analyse a manager’s track record in more depth and look even more closely at both the individual team member skills and the way the team works as a whole,” says Nielsen.  It is a sign that institutional investors have become more demanding of their real estate investment managers. Edwin Meysmans, managing director at Pensioenfonds KBC, in Belgium, says: “We have increased the amount of due diligence we carry out and so raising capital now takes a lot longer than it did before the crisis.” According to Meysmans, the exacting standards of the larger schemes blazed a trail when it comes to being more specific in their demands. He says: “The larger pension funds have been very proactive in setting the terms of their real estate investments when it comes to leverage, transparency and communication. Smaller pension funds, like ourselves, have benefited greatly from this.” Reflecting on this, Rikard Kjorling, head of external managers at AP1, one of the Swedish buffer funds with SEK218.8bn (€28.9bn) in AuM, says: “We always expected very high levels of transparency and service and this didn’t change throughout the crisis. Due to our high standards we didn’t encounter some of the problems some of our contemporaries did, especially when it came to real estate. We have a very rigorous manager selection process and we have always been picky about the partners we choose. “Since the financial crisis, power has shifted towards the owners of capital as opposed to those who manage it. It’s quite obvious that those who hold the liquidity are in a better position than they were before.” Greg MacKinnon, director of research at the Pension Real Estate Association, says: “While during the upswing there was a lot of capital chasing a limited number of investment opportunities, post-crisis there was a relative shortage of capital which meant that the bargaining power swung to the capital providers.” Despite the changes taking place, some institutions still find that fees are an issue. Nielsen says: “Unlisted real estate exposure is still very expensive when compared to asset classes, but although we haven’t seen a huge change in the fees on offer, fund managers are now more open to negotiation.” He adds that because real estate is more expensive than other assets, the investment manager has to work harder to justify the fee package. What he says has changed, though, is that fee packages and structures have become simpler post-crisis. MacKinnon says: “The asset management fee is often justified as simply covering the costs of the manager, who then profits on the carried interest. But now investors often question the size of this number and, in some cases, they have asked to look at the financial numbers of the management firm itself in order to judge whether the size of the asset management fee is justified.” Open dialogue
Investors also expect better communications from their managers. Meysmans says: “Open dialogue has become very important since the crisis, when some managers were afraid to pick up the phone and tell us things were going wrong. But we would rather hear it from them than read about it in the papers.” Yet another element that has steadily climbed up the priority list is alignment of interests between client and adviser; one way of achieving this is to have the investment manager, or the members of the fund management team, co-invest alongside the clients. But this does not seem to be working as well. Nielsen says he has not seen much change in the way the interests of investors are aligned with those of the manager. “I haven’t seen a huge step in the right direction. Managers are not offering the levels of alignment interest we would like to see,” he says. According to Nielsen, the alignment needs to be as close as possible, although he does point out that the amount the fund manager or the fund management team need to co-invest differs on a fund-by-fund basis. A definite change in the post-crisis, real estate-investing environment is the institutions’ tolerance to risk and leverage within their investments. In real estate, much like in most other asset classes, exorbitant levels of gearing are now out of the question. Meysmans says: “Too many real estate funds had very high levels of leverage before the crisis hit. Now all investors are looking to decrease their exposure to leveraged real estate funds.” He says that the maximum gearing he is willing to accept is around 30-40%. He adds that he is more focused on cash flows in the post-crisis environment. “Income yield is more important than the potential capital gains to be made from the ultimate sale of the property. Characteristics like long-term leases, which are slow yielding but have a long horizon, are very attractive.” Risk tolerance at Denmark’s ATP has also come down for the time being. Nielsen says: “We have now climbed down the risk curve and are more focused on core investments rather than opportunistic ones. Our average gearing target is at around 50% now. It used
to be 60%.” Kjorling, however, says that AP1 has not changed its view of risk dramatically. “Our view of leverage remained pretty stable throughout the crisis. Although we do see that around the world tolerance for risk has gone down dramatically, we have had tolerable gearing along the way and never went to excessive levels. Our normal level is 50 to 60%.” This is a function of the fund’s real estate strategy. Kjorling points out that when it comes to other strategies, “the ‘normal’ level can be something else”. ©2011 funds europe

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