Designing and Operating Open-Ended Real Estate Funds

Recent years have seen a resurgence of interest in open-ended funds, and an increased recognition of the challenges that come with developing and operating them. Sensus recently spoke with John Forbes, Partner at John Forbes Consulting LLP, about the evolving global landscape for evergreen real estate funds. John Forbes is an independent consultant advising real estate investment managers, investors and others in the real estate industry on the structure and operation of real estate funds. 

Much of what we see in the current design of open-ended real estate funds for institutional investors can be traced back to lessons learnt during the global financial crisis. As well as improvements to governance and transparency, a key theme to emerge was that institutional investors wanted a form of fund that sat somewhere between a traditional closed-ended fund and a traditional open-ended fund.

Many institutional investors were investing in open-ended funds not because they wanted short-term liquidity, but because they wanted to deploy capital for the long-term. They did not want to be tied into the short term prospects of a closed-ended fund, returning their capital and leaving them the challenge of reinvesting it.

The cost of investing in real estate is relatively high compared to other asset classes, largely as a result of the taxes on real estate transfers. In a long-term, low return environment, this has grown even more important. Investors want to hold assets for longer. There is a trade off between liquidity and volatility, and investors have been increasingly willing to sacrifice some of the former to minimise the latter.

Defining and Managing Liquidity Risk

Open-ended funds have long followed two broad models on how subscriptions and redemptions are managed:

• Redemption frequency matches subscription frequency, typically quarterly. If this route is followed there need to be significant limits on the ability to redeem units due to the relative illiquidity of the underlying assets.
• Redemptions are less frequent than subscriptions. There is wide variety with this, with different funds having redemptions possible between every six months and every ten years.

Wherever on the spectrum the manager decides to place a fund will depend on the nature of the fund, the target investors, the underlying property, and the anticipated borrowing of the fund. 

Determining the frequency of redemptions is, of course, only part of the story. Other key liquidity tools include notice periods, the length of time to meet redemptions in different circumstances, gating provisions that restrict the amount that can be redeemed at one time, and the mechanics of how queuing works as investors await redemptions.

The International Organization of Securities Commissions (IOSCO) is the regulators’ regulator and has taken a keen interest in fund liquidity. In February 2018, it published two key documents that set out its views. These were the outcome of a consultation conducted in 2017 and are very broad bush as they are intended to provide a framework for local regulators across the globe for all forms of funds and all asset classes where there might be a mismatch between the liquidity of the fund and the liquidity of the underlying assets. The IOSCO recommendations do not apply directly to fund managers but are hugely important as they are now starting to be reflected in local regulation.

Defining and managing liquidity risk is a key aspect of designing any open-ended fund investing in real estate, or indeed any other less liquid asset.

Open-Ended Rund Pricing Models

Fund pricing is another area in which there have been recent and important developments. There are three broad methodologies for adjusting accounting Net Asset Value (NAV) to calculate the price at which investors subscribe and redeem:

• Capitalisation and amortisation (typically INREV), popular in Europe;
• Classic dual pricing, popular in the United Kingdom;
• Do nothing, popular in the United States.

The key determining factor is the taxation of property transfers, which is not a material issue in the United States, hence the lack of interest on that side of the Atlantic. 

In Europe and the United Kingdom, there has been a recognition for some years that current open-ended fund pricing models have lacked sophistication and there has been a working party from INREV (the European Association for Investors in Non-Listed Real Estate) and AREF (the Association of Real Estate Funds in the United Kingdom) working on this since 2017. They published their final conclusions in May 2021, bringing changes to both classic dual pricing and INREV capitalisation and amortisation. The most significant changes are: 

• For classic dual pricing, the subscription price should reflect the anticipated cost of deploying capital, rather than the assumed cost if the whole portfolio was notionally disposed of and reacquired;
• For INREV capitalisation and amortisation, there will now be a divergence between INREV Reporting NAV and INREV Trading NAV.
  • For INREV Reporting NAV, acquisition costs will continue to be amortised over five years.
  • For INREV Trading NAV, used to calculate the subscription price, amortisation will now be over the expected hold period of the asset.

Amortisation periods of setup, acquisition and financing costs should be adapted to the planned holding period of a vehicle. For evergreen vehicles, asset specific features should determine the amortisation period and, in their absence, a 10-year period is recommended unless there is a specific asset feature which requires deviation from this period. This approach and rationale should be disclosed in the constitutional documentation when an investment vehicle is being launched.

A key feature of both of these is an increased level of subjectivity and judgement. As a result, the AREF/INREV working party also made a number of recommendations with respect to the governance of open-ended fund pricing. Both AREF and INREV are taking the governance proposals forward as part of broader considerations via their respective corporate governance committees.

Hitting a Moving Target

There are two related areas that are not specific to open-ended funds but are evolving very rapidly and creating challenges for investment vehicles that are designed to be perpetual in nature, regulation and practice: ESG and taxation. 

It is impossible to miss how dramatically Environmental, Social and Governance (ESG) frameworks haves risen to the top of the agenda, particularly the E. The way in which fund managers approach this is changing with the introduction of extensive regulatory requirements in respect of ESG disclosures.

In the European Union, fund managers are already having to comply with the first stages of the Sustainable Finance Disclosure Regulation (SFDR) and we are starting to see its impact on the approach that investors are taking. With this, both managers and investors face a challenge. The first attempt by the EU at Regulatory Technical Standards (RTS) had been written with investment in securities in mind and was broadly unworkable for real estate as an asset class. Following lobbying from the real estate industry, the RTS was amended to include real estate metrics. However, there remain problems with the proposed measures and the RTS do not correspond to the EU Taxonomy published shortly afterwards, and as such are being rewritten.

The UK is also introducing a regulatory framework for ESG reporting for fund managers and investors. The Financial Conduct Authority (FCA) ran a consultation on this which closed in September. The importance of this goes well beyond the UK, as it seeks to apply the international Task Force on Climate-Related Financial Disclosures (TCFD) recommendations. These too are designed for investments in securities, so the TCFD is closely watching developments in the UK. Real estate industry responses to the UK consultation have suggested that the FCA (and thus the TCFD) should use an existing real estate methodology for the real estate metrics. The broad consensus is that the most appropriate tool for this is the Carbon Risk Real Estate Monitor (CRREM).

The particular challenge for managers launching open-ended funds is hitting such a rapidly moving target for fund documentation for a vehicle that is intended to be permanent. There is no easy answer.

As with ESG, there is a challenge in attempting to hit the moving taxation target, which has three key aspects for open-ended funds:

• Tax legislation is changing, and through the OECD Base Erosion and Profit Shifting (BEPS) initiative, the measures to tackle tax avoidance are international;
• The attitude of institutional investors towards tax planning is becoming more conservative. Danish pension funds are leading the charge in this area. Open-ended funds tend to be lower on the risk spectrum and should also be lower risk in their approach to tax;
•  Tax assumptions are a key element of the adjustments to NAV for subscriptions and redemptions for open-ended funds, particularly for INREV Reporting NAV and INREV Trading NAV.

This discussion only scratches the surface of a highly topical but increasingly complex subject. Time spent upfront on the detailed work on the structure and operation of the vehicle is important in the creation of all funds. The longer the duration, the longer you have to live with the consequences of your decisions. Open-ended funds are intended to be permanent. In the words of William Congreve, married in haste, we may repent at leisure. 

This article was originally published in Sensus Magazine. Click the image on the right to flip through our most recent issue or browse through our previous editions of the magazine.