Unlisted real estate funds – back to basics for SMSF investors
The GFC has reminded all real estate fund managers that you are investing other peoples money
, and you should always put their interests first. From an
SMSF investors viewpoint, the GFC reminded them how important it is to select the right manager, and fund.
A number of
DIY Superannuation investors in both unlisted and listed real estate funds got burned in the past few years. As a result, a new level of scrutiny will be applied to real estate fund managers by investors and their advisers.
Investors generally understand that markets have cycles, and investment values may go up and down. Over the years, we have found most investors are quite pragmatic so long as the manager is upfront about the facts, can clearly articulate the reasons why and demonstrate how they plan to rectify under-performance.
Markets are based on trust and confidence. Whilst we can point to many real estate funds and managers that have delivered on their promise of stable wealth creation, there have been some notable high profile causalities.
Those managers and their funds that came unstuck, typically had one or more of the following issues:
-opaque structures, with little or no transparency;
- high leverage which was being used to super-charge performance rather than relying on the real estate skills of the manager to drive performance;
- poor communication with their investors;
- high fees that were weighted towards acquiring assets rather than delivering outperformance to investors;
- payout ratios that were unsustainable i.e supplementing income distributions with unrealised capital gains, often funded through increased gearing;
- investment strategies that changed, and in some cases, skewed the risk/return profile of the fund; and,
- poor corporate governance and risk management practices.
One of the hottest issues being debated at present is that of manager remuneration. In a number of the unlisted real estate funds, the fee structure was biased towards very high front end fees, with a smaller, on-going management fee and a performance fee that was payable even in cases when managers did not do much more than ride the real estate boom . This meant the focus was more on growth in funds under management, rolling out fund after fund (asset gatherers), and not focusing enough on the on-going management and the timely exit of the asset to maximise investor returns (investment manager).
This is not to say that acquisition fees are not appropriate. Real estate is a lumpy asset with due diligence costly in both time and money. Also in a hotly contested market, where fundamentals are put on the back-burner, the diligent manager often pulls-out of the bidding war because they cannot justify the price. As a result, unlisted real estate fund managers have a case for charging a fair and reasonable acquisition fee. The key is getting the right balance between fees for acquiring the real estate and fees for actually out-performing for an investor over the life of the asset or fund. Our view is very much that the fees should be more back-ended. If our investors do well, then the manager should share in some of this outperformance.
A key issue with performance fee structures is how the manager should be rewarded absolute outperformance (i.e giving a positive return over a hurdle rate that truly reflects the investment strategy) or relative performance to a market benchmark that may have both positive and negative performance. Like most things, there is no right or wrong answer. The key is to ensure that the performance benchmark is set at an appropriate hurdle that reflects the strategy (i.e the risk/return trade-off of a particular investment strategy). The fee should appropriately reward the manager for value-added performance delivered to investors.
Real estate is an on-going business which requires skills in acquiring, managing, leasing and developing real estate. Of course, capital management skills are important but without the right assets, no amount of capital management/financial engineering skills are going to deliver strong, consistent performance to investors. The good real estate fund managers are asset enhancers they create value through their ability to add value through-out the lifecycle of an asset.
Going forward, it is clear investors want a back to basics true to label approach'. Simply put this means:
- simpler, more transparent structures;
- lower levels and better management of leverage ;
- focus on sustainable income;
- sustainable payout ratios;
- greater transparency;
- better communication;
- fee structures than align interests between the investor and manager; and
- independent oversight and exemplary corporate governance.
Those unlisted real estate fund managers that will survive and prosper are the ones that can adapt and respond to the changes being demanded by investors and their advisers.
As Charles Darwin said "it is not the strongest of species that survives, nor the most intelligent that survives. It is one that is most adaptable to change".
Adrian Harrington
Executive Director Funds
Equity Real Estate Partners
Unlisted real estate funds back to basics for SMSF investors
By: Graham Parkes
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