Chairman's Corner september 2009

Non-listed fund managers – Lessons learned

Earlier this year Marleen Bosma-Verhaegh and Peter van Gool published an interesting study on issues that institutional investors are facing and the lessons learned when it comes to non-listed real estate funds and the current economic crisis. A summary and our take on this study can be found in our Fall 2009 edition of the Property in Perspective.

For a fund manager like IBUS, however, there are also lessons to be learned from the significant down turn in the economy in general and the slump in the real estate industry and investor sentiment in particular. Of course buying AND selling the right real estate investments at the right time once again turns out to be the best hedge against a recession. In that respect IBUS can be proud to show a good track record and currently enjoy a very stable property portfolio. That said, one of the more important business related issues for any fund manager and its fund investors is the guarantee of a going concern of the manager. This of course is directly linked to an issue that is stated in the above mentioned study and from our perspective deserves further attention: fee related issues.

Before we get down to the very simple nuts and bolts of what kind of fee structure is required to guarantee a going concern for a fund manager, it is good to take a small step back in time. Already since the 1970’s and 1980’s specialized real estate syndicators and asset management organizations were common place in the US, although the size of this market was fairly limited. Changes in tax law and the down cycle in the real estate industry in the late 1980’s and early 1990’s diminished this industry in the US substantially. It wasn’t until the middle of the 1990’s that, concurrently with Europe, the growth of this industry picked up again. And this time, the growth was substantial. This growth was mostly triggered by two major developments: (1) institutional investors changing from in-house management of real estate to outsourcing of real estate (fund) management and (2) the growth in accumulated wealth of High Net Worth Individuals and their related growing want to invest in real estate.

These developments occurred at the same time that the real estate industry started an unprecedented growth cycle that would last almost 13 years (roughly 1994 – 2007). Of course we experienced some dips along the way (Russian wodka crisis of 1998, the bursting of the dot.com bubble in 2001), but they were short, shallow and, especially, soon forgotten. Why is this important? Because it made us focus on future income more than on current income.

When the institutional investors started outsourcing their real estate management, what it did not result in was the disappearance of the cost to manage real estate portfolios. These costs were simple transferred to separate, independent enterprises, the real estate fund managers. What it resulted in for the institutional investors that previously managed real estate in-house, is lower overhead costs (were these ever taken into account when calculating returns on direct real estate holdings?) and larger flexibility. The real estate fund managers, some of which were the previous in-house departments of institutional investors, took on a greater risk though: there no longer was a guarantee for continuous work. To mitigate this risk, additional fees were introduced that were triggered by transactions being done: acquisition fees and performance fees. In a continuously improving market, it is especially the performance fee that is attractive. Certainly in a business that is capital intensive and where small increases in percentage-points return improvement translates in large monetary payouts to fund managers.

The continuously increasing prices of real estate brought one problem with it, though: dividend or cash yields became lower and lower. One of the obvious and easy ways of improving dividends is lowering asset management fees. Pressure from investors to do so increased, also driven by the fact that the enormous fees that fund managers (on paper) were making from transaction related fees, needed to be offset by other fees payable to the manager. For that same reason, fund managers were willing to accept trading in fixed income for variable income. In some cases, especially where it concerns funds that were specifically aimed at introducing real estate funds to the low end of the High Net Worth Individual market, asset management fees would be forgone completely and fund mangers would accept the fact that they would be entirely rewarded by one-off transaction fees.

So where does that leave us as fund manager, what is the important lesson learned? It is as simple as this: asset management fees matter! Since they provide for stable income in bad times, they help in guaranteeing a going concern and therefore they do help in aligning the interest of a fund manager with that of the investors. Asset management fees will have a negative impact on the direct return of real estate funds. It would be good for investors to realize, however, that these costs merely reflect the cost of outsourcing what otherwise would have been done in-house. And perhaps it would be good for fund managers to come to the realization that asset management is a business that should reflect steady income and is not based on the volatility of transaction related profits stemming from spreadsheets. Perhaps it is part of the further maturing of the real estate asset management industry that we come to the realization that asset management is a medium to low margin business that requires substance to make larger profits.

That does not mean that there should not be any acquisition or performance fees involved with fund management. The first is a reward for the fact that most of the time spent on sourcing and analyzing deals will not always result in an acquisition. And the second does give an extra incentive to both optimize an asset management strategy as well as execute an exit strategy. But they do not necessarily build a sustainable business.

At IBUS we have been able to adjust our portfolio in time to be more recession proof and as a result not only helped the sustainability of the IBUS organization, but also increased the stability of the investment portfolio of our clients. It does not mean that we are not facing any challenges in the portfolio. But at least we know that we will be able to get through the challenges based on realistic, recurring asset management fees, which is a positive to the investors in our funds as well.

Pepijn Morshuis
September 2009