Revival, not recovery, for private real estate

April 2013 | FEATURE | REAL ESTATE

Financier Worldwide Magazine

The private real estate market has endured a turbulent few years. Since the global economic crisis bit, the industry has had to withstand not only a number of structural and legislative changes, notably in the form of the Dodd Frank Act and the Alternative Investment Fund Managers Directive, but it has also had to contend with fundraising issues and stagnant deal flows across many markets. In light of these challenges, many investors have turned away from the industry in recent years.

It would appear, however, that optimism is slowly beginning to return to the real estate market. Despite macroeconomic conditions remaining uncertain, particularly in Europe, and many funds enduring a lack of liquidity, after years of instability, the private real estate market is starting to adapt to a new paradigm. While it is too early to say that the market has recovered from the dark days of the economic crisis, a revival is clearly under way. As financial and economic stability has started to return, it has brought with it renewed confidence within the real estate sector.

Alternative asset research company Preqin supports this assertion. Its report ‘Investor outlook: real estate H1 2013’ suggests that investments in private real estate funds are growing as investor appetite for the asset class returns.

For the report Preqin surveyed more than 100 investors in private real estate funds. According to that survey the majority of investors, 53 percent, expect to make commitments to private real estate funds in 2013. This figure compares favourably with a similar survey the firm carried out over 12 months ago, when only 36 percent of respondents expected to make investments in the year ahead. This increased confidence in the asset class comes after many funds performed steadily throughout 2012. Furthermore, 54 percent of investors expect to commit more capital to funds over the next 12 months than they did during 2012. Only 3 percent of surveyed investors expect to commit less. Andrew Moylan, manager of real estate data at Preqin, notes that “There are strong signs that investor confidence in private real estate funds is returning”.

Despite the increase in overall investor appetite, there are still a number of caveats which must be considered. Of those respondents that had a defined investment plan, 43 percent of investors only intend to make one or two new commitments over the next 12 months. Although most investors noted that they plan to invest more capital in 2013 than they did in 2012, increasingly they are choosing to focus on making larger investments while sustaining relationships with fewer fund managers.

Investor interest in first time real estate funds has also been falling over the last few years. Preqin’s data suggests that 66 percent of investors would now shun first time funds; this figure has risen sharply since 2009 when only 28 percent of investors responded negatively to start up funds. These responses demonstrate the fragility of investor confidence. Although investors and funds are happy to seek out more risk-heavy investments, they are quite risk averse when it comes to the vehicle for that investment. Investors are increasingly searching for firms and fund managers with a strong track record of success in the sector.

The report also suggests that as bank financing dried up around 2008, debt funding became increasingly popular in the contemporary real estate industry. Preqin’s data suggests that investors are being drawn to real estate debt as they believe debt funds can generate greater returns than equity investments. Thirty-four percent of respondents noted that they would be targeting debt funds during 2013 compared with only 8 percent the previous year.

Innovation out of adversity

It is clear that the industry is still facing numerous challenges. Undeniably, the increased scrutiny fund managers face under the regulatory microscope may be problematic for some within the industry, as might the progressively severe demands placed upon firms by investors. However, some fund managers are utilising the new regulated working environment to help drive firms forward, creating new methods to improve operational efficiency and reduce costs in the process. Indeed, in the current uncertain and shifting economic climate, creative investors can blossom. Ernst & Young’s global market outlook report suggests that although, in the short term, firms may find the increased glare of regulatory analysis to be challenging and daunting, in the long run operating in the current tightly-regulated environment should make it easier for fund managers to “create efficient, transparent and scalable platforms, which will, in turn, attract a wider range of investors from around the world to the real estate funds sector”.

Innovation often involves risk, and there seems to be a consensus among analysts that the most notable form of fund likely to draw investment during 2013 will be the value added fund. Value added funds are considerably more risky than conventional core funds as buying, developing and selling properties are all involved. Although they are more perilous for investors they tend to provide markedly higher yields than other types of funds. In the immediate aftermath of the financial crisis many investors coveted and pursued more conservative core investments, however, that attitude is clearly changing. Value added funds are now en vogue as investors look to move up the risk-return spectrum.

According to Preqin’s report, 55 percent of all investors surveyed plan to invest in value added funds in the next 12 months, up from 45 percent in the 2012 report. Forty-four percent will also pursue core plus funds. This shift towards value added funds may be a result of the potential higher yields offered by the riskier form of funds, or it may, as Preqin proposes, be due to investors feeling that core assets are becoming overpriced. Since the financial downturn, investors have predominantly favoured core assets. Core funds will remain attractive to investors, with 45 percent of respondents noting that they will be targeting core real estate funds over the next 12 months. This, however, represents a 2 percent decline based on the 12 months following 2011.

Opportunistic, debt and distressed funds were noted as being the least popular funds with investors in Preqin’s report. However, although the majority of investors seem to favour value added funds, many investors are also targeting distressed and debt vehicles. Thirty-four percent of investors will be pursuing debt funds, compared to just 8 percent of those surveyed in December 2011. Twenty-five percent opted for distressed funds and 44 percent chose opportunistic funds. The opportunity to generate strong returns with a markedly lower level of risk is one of the key reasons for investing in funds pursuing a debt strategy.

While many investors are maintaining an air of caution around the volatile Southern Europe region, they are prepared to search for more high risk opportunities in more stable environments. Areas such as Munich, Berlin and London are increasingly popular with funds as they search for value, particularly outside prime locations and sectors.

PwC’s report ‘Emerging Trends in Real Estate Europe 2013’, suggests that firms looking to move into more risky sectors must do so in a thorough way, noting that “This is where those who specialise, who have detailed local knowledge, and who can create networks in regional markets will prosper. Investors are exploring off the radar locations, learning how the local economies of those areas function, and seeking relationships with local operators to help them do that”.

Emerging markets and the US

Outside of the US, where many internal investors are feeling bullish, investment opportunities are springing up in the emerging markets, most notably the Asia-Pacific region. Eighty-three percent of US investors surveyed by Preqin noted that they will be investing at home in the 12 months from December 2012. Eighty-five percent of Asia-Pacific investors also stated they would be investing in their own region. European investors were not so optimistic – only 69 percent of European investors said that they would be targeting investments in Europe in 2013. Here, Preqin’s findings support PwC’s, noting that investors generally invest in their own local markets due to greater knowledge of those areas. The comparatively low response from European investors points to the continued economic and political uncertainty in the area.

As the global economy continues to recover from the stresses and strains of the financial crisis, it is increasingly clear that the unfolding economy will be different from that which preceded the financial meltdown. While there are, and will continue to be, areas for growth and profit in the post crisis economy, those areas and how investors pursue them are changing. While the industry is showing promise, it is not yet out of the woods. In the coming years we will see opportunities for growth in the private real estate market but that growth will be sluggish. Although confidence has been slow to return to the US market, it is finally moving in the right direction. Data from the National Council of Real Estate Investment Fiduciaries supports this, showing that private real estate values in the US rose by 10.5 percent in 2012. Certainly, the recovering US and the emerging markets will be the relative hotbeds of real estate activity for the foreseeable future. Outside of Europe, it would appear that investors are adopting a more optimistic stance regarding their domestic markets.

Confidence in Europe, meanwhile, remains low. Although US investors are less pessimistic about the continent than they were 12 months previously, investment is still unlikely to flood into the region over the next year. Only 20 percent of Preqin respondents expected their firm to target an investment in Europe throughout 2012. Of those positive respondents, most firms are likely to steer clear of the troubled Southern European states, which continue to be the most unstable nations in the region. Investors are more comfortable with the stability of Northern Europe and believe the region will provide investors with excellent opportunities for growth in 2013.

On the whole, the real estate market is slowly beginning to regain its confidence. Furthermore, investor appetite for real estate opportunities is increasing. The global economy, much like the real estate market, is showing signs of life. Yet it will be ‘revival’ and ‘relative optimism’, rather than ‘recovery’, that will be the watchwords for firms and the industry going forward. The private real estate market is slowly adapting to a ‘new normal’.

Richard Summerfield