Pan-European real estate fundsDOWNLOAD
Over the last decade the real estate fund industry in Europe has enjoyed quite exciting times following trends initiated in the US market where investment vehicles with a global scope and strategy met investor demand for mixed-asset portfolios.
Investors wanted to benefit from diversified opportunities offered through vehicles investing in different regions and different sectors to take advantage from low correlations between regional and sectoral economic cycles. The proliferation of Real Estate Investment Trusts (REITs) as well as the emergence of non-listed vehicles offering greater flexibility adequately served this market expansion. The “boom” sector was driven by economic growth as well as by demographic factors including an ageing population researching property acquisition opportunities in Western Europe and the growing urbanization of a young population in Asia.
As a result, once the concept of creating an alternative vehicle to invest in geographically diversified real estate started to gain momentum, it did not stop. Europe did not miss the opportunity and the Real Estate Fund sector emerged as a true success story with an ever increasing number of vehicles being launched in a growing number of jurisdictions. Luxembourg, UK, Germany and the Netherlands became the most developed European real estate fund markets and other European countries also realized the importance of offering specialized real estate vehicles to investors seeking to benefit from steady and uncorrelated returns on real estate portfolios. Amongst these four countries, Luxembourg is the only one which has truly succeeded in delivering a cross border and global investment platform. The number of different vehicles available became significant but research has demonstrated that non-listed open ended vehicles were over time favored by professional and sophisticated investors to gain exposure to this market.
Europe quickly became one of the leading Real Estate Fund markets in the world and jurisdictions combining a sophisticated but flexible fund regime and opportunities to launch flexible structures to optimize tax burdens became domiciles of choice for non-listed vehicles. These are particularly utilized by institutional investors because of their adaptable features that enable the design of structures that are tailored to investors’ fiscal specificities, the nature of the expected returns and the fiscal features of the underlying investments. There are a number of tax costs which should be monitored to deliver high yield to investors. The efficient tax structuring of real estate funds can usually reduce the effective tax rate down to 3-4% for Pan-European Real Estate Funds. It is paramount for fund promoters to deliver highly tax efficient returns to their investors in order to compete in this market.
There are many different real estate funds or investment vehicles available in Europe, making it very challenging to decide on the most appropriate structure. The minimum investment threshold, the liquidity of the investment, the flexibility of income distributions models or the required diversification of the property portfolio are all factors that need to be considered, and differ significantly from one country (or fund) to the next.
According to INREV the number of non-listed real estate funds launched in Europe peaked in 2006 and 2007. Since 1998, the number of new non-listed fund launches in Europe has increased from 40 to more than 500 funds in total at the end of 2008 with assets under management close to €300 billion.
Following years of impressive returns for the real estate industry worldwide, the sub-prime crisis hit the US and quickly spilled over into the European markets, strongly affecting Central and Eastern European markets where international investors divested . Since then, the growth in the number of funds launched has deteriorated very significantly. This, together with the fact that a significant number of funds is expected to terminate within the next five to ten years, paints a completely different picture of the European real estate fund industry compared to what was envisioned only few years ago.
The sub-prime crisis, and the badly timed global economic crisis has resulted in suppressed transaction volumes and limited access to financing. Real estate remains a relatively worthy investment option, especially as the performance of other competing asset classes has been very volatile. Despite this, the real estate sector itself faces several challenges in 2009 of which the biggest is debt maturity and breach in loan to value covenants. A significant number of funds had to renegotiate the terms of their loans and quite a few funds have debt coming due in 2009-2010; however, it is becoming increasingly difficult to access credit to refinance that debt and to deploy the intended investment strategies.
In Europe, the debt market for real estate investments has shrunk considerably since 2008, if not dried up entirely. Fund managers have the enormous task of figuring out how to use the limited cash flows in place in order to service their current debt levels and if possible, continue to grow and deliver attractive returns.
Obtaining new debt or extending debt currently in place for most real estate funds has been a challenge since the New Year. Factors which exacerbate the issue are that funds sometime limit themselves to only going to a few lenders to contain costs and counterparty risks rather than broadening their sources of finance among as many lenders as possible. In addition, funds tend to be drawn to lenders who tend to lend nationally first to support domestic markets and justify the support provided by their governments when difficulties severely hit certain banking groups. So far we are yet to see the benefits of these drastic measures.
Both factors further limit a fund’s potential to find new debt which is already limited to start with, given the economic situation. More importantly, however, it also reduces the options a fund manager has in the decision making process. As real estate funds are generally not over leveraged they might not appear as very problematic, however lenders will follow very closely the evolution of funds and in particular pay extreme attention to valuation methodologies, their reliability and independent source.
However, when financing at reasonable rates becomes more readily available, the floodgates should open, because real estate continues to attract domestic and international investors. Two factors, in particular, could help get transactions moving again: First, if banks were more willing to provide financing it could impact the number of transactions on the market. Second, if landlords whose tenants are facing bankruptcy were willing to temporarily restructure their lease agreements, it could keep those retailers in business and head-off the need to find replacement tenants in a very difficult environment.
It is likely that the real estate funds sector will recover as soon as the global economic outlook improves and will reach its previous level of appeal in delivering steady returns in excess of other asset classes. Real Estate Funds, however, benefit from only very limited access to cross border markets. It is not foreseen in any future development of the current pan-European regulatory framework governing investment funds to allow EU harmonised investment funds (i.e. UCITS products) to have direct exposure to real estate assets other than via limited investments in shares of REITs or listed companies active in the property business.
Funds may be structured to invest in multiple countries, however the marketing of EU regulated Real Estate Funds on a cross-border basis is still encountering significant barriers to being authorized for distribution to the public; active and large-scale marketing activities limited to professional and institutional investors might be difficult in certain countries. Domestic regulations are not adapted to recognize equivalence of foreign regimes and of foreign vehicles hence refraining from granting authorisations. In addition, Europe lacks harmonized private placement rules for financial products which makes real estate Funds players reluctant to each time undertake legal research that can prove to be a very costly exercise.
In 2007 the EU Commission mandated a group of experts to analyze the market of Real Estate Funds and their regimes in Europe amid concerns that the sector was growing and raising its profile while still bound by national barriers that limited its expansion and the creation of a properly regulated single market. Furthermore the absence of a harmonized concept of private placement for investment products falling outside the UCITS framework is limiting development opportunities.
The Expert Group on Open Ended Real Estate Funds (OEREF) appointed by the EU Commission argued that the main reason why investors will seek alternative methods of investing is because of a lack of a European regulatory structure for open ended funds and the difficulties in cross border marketing. They are of the opinion that EU consumers will be better served if regulated Open-Ended Real Estate Funds could be sold effectively and efficiently across EU borders. The Expert Group advocated EU legislative intervention to create a dedicated EU harmonized regime to support the expansion of this product segment and made recommendations on the essential features that such funds should comply with. Those essential features were building blocks proposed by the Expert Group meant to set the ground for a European open-ended Real Estate Funds regime creating the same time a form of EU passport for regulated real estate funds. In a nutshell the proposed essential elements can be summarized as follows:
The Expert Group also drew attention to the need to remove or at least soften tax barriers at investor and investment levels that in certain countries penalize foreign Real Estate Funds versus domestic products that very often only focuses on investments in domestic property sectors. As the Expert group concluded “…clarification of a common regulatory approach (harmonized rules) would form an effective basis on which to reach common agreements on consistency of fiscal approaches to OEREF” .
As such an initiative would certainly require significant legislative adaptation in certain Member States to enhance or simply to create such a regime, it is worth noting that Luxembourg Specialised Investment Funds regime governed by the Law dated 13 February 2007 already reflects almost all of the above provisions. Should such a regime ever become a European reality, Luxembourg would be in the forefront to embrace the opportunity with very little need for amending its legal and regulatory framework.
The systemic risks that the financial industry as a whole had to face since the beginning of the global economic crisis, lead the EU Commission to take a different stance in the matter.
Earlier this year, the EU Commission issued a draft directive on Alternative Investment Funds Managers (AIFMD). The purpose of the draft AIFMD is to create a regulated regime imposing a number of operational, regulatory capital, governance and disclosures obligations for all managers of non-UCITS funds in Europe, at least in so far as they manage more that a given threshold set at € 100 million (€ 500 million if the funds have no leverage and do not allow redemptions prior to their fifth anniversary). The corollary of the draft AIFMD regime is that funds managed by such alternative investment managers would be allowed to market their funds to professional investors on a cross border basis via a simple notification to host Member States (in practice creating a sort of limited passport for alternative investment funds).
The draft Directive has caused a lot of reaction amid worries that the approach taken did not only take insufficient account of industry concerns, but is also of the “one size fits all” type. The draft Directive is particularly criticized for aiming at all forms of “alternative” products without allowing taking into account the specificities of the very diverse industries that form the “alternative investment management” world in Europe. Managers of hedge funds, real estate funds or private equity vehicles all fall within the scope and shall have to adapt to the obligations imposed by the draft AIFMD.
Far from addressing the preference expressed by the Expert Group for a dedicated OEREF regime, the EU Commission has issued a catch-all type of regulation that, although not criticized on its objective to bring more transparency and harmonized regulatory approaches to the sector, does not take into account the specificities of each industry without permitting any specific exemptions. It would, for example, cover fund managers in industrial or financial groups running in house capital through separate vehicles in the same manner as professional managers designing and launching Real Estate Funds for the purpose of distribution to external investors.
The coming weeks will be very interesting as it is likely that the Swedish Presidency of the EU and the EU Parliament are expected to take public reactions on board and propose significant amendments to the draft Directive.
2010 and 2011 will be very challenging for the Pan-European Real Estate Fund industry and the road ahead promise to be bumpy but also full of opportunities. The recent more positive outlook in the economy is providing a sense of hope that the appetite of investors for real estate as an asset class will return. The future of the Pan-European Real Estate Fund Industry looks again promising provided it will manage to face off the challenges in respect of changing regulatory environment. A much needed market stimulation stemming from more available financing will be the first hurdle to overcome.
Luxembourg has positioned itself very strongly for the re-bound and should keep its place as the jurisdiction of choice for setting up Pan-European and Global Real Estate Funds. The Association for the Luxembourg Fund Industry (ALFI) is lobbying very strongly to have the right framework in place and working with specialized service providers to develop stronger platforms to deliver cross-border investments.