REITs and funds: coming together to target the middle ground

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1 REITs and funds: coming together to target the middle ground

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3 REITs and funds: coming together to target the middle ground The activities of real estate investment trusts (REITs) and unlisted real estate funds often overlap particularly in competing to buy, develop and ultimately own similar types of property. Both products are used extensively by institutional investors. On the other hand, retail investors have limited means to access commercial property. Minimum investment requirements and inaccessible sales channels make private real estate funds accessible to only the ultra high-net-worth investors. Building size and value makes direct ownership challenging, especially from a diversification perspective. This leaves accessing listed REITs either directly or through listed or mutual funds as the only viable option. We think there is a huge opportunity for products in the middle ground, incorporating the best features of both REITs and real estate funds to become increasingly accessible to retail investors, and institutions of all sizes. New vehicle structures and technological solutions, particularly those facilitating capital raising in an increasingly cost-efficient and transparent manner, will provide opportunity for future growth. In the US, this likely involves making greater use of the non-traded REIT market, while outside the US, the number of externally managed listed REIT products continue to proliferate. These vehicles also provide opportunities for real estate fund managers to collaborate in order to access new sources of capital and may ultimately lead to further consolidation in the real estate funds industry. Real estate s next frontier facilitating wider access to retail investors The case for real estate as an investment class is well publicized, 1 with the low correlation to both stocks and bonds being one among its many attributes. Sophisticated institutional investors have long capitalized on these and other attributes, and allocations to real estate continue to increase, up from 8.0% in 2012 to 8.5% in By comparison, retail investors appear relatively underweight in the asset class. In the US, mutual funds are a primary conduit for retail investors, often via 401(k) plans. Citi estimates US mutual funds (MFs) own approximately US$232b of the US REIT market, which represents 28% of REIT market cap. That US$232b could be significantly higher, given it represents only 1.3% of all mutual fund holdings; a relatively small proportion compared with the 2.7% weighting of real estate in the S&P 500 GICS sector index. Retail investors do own a further US$133b of REIT equity directly, but alternatives (not just real estate) were estimated to account for only 4% of high-net-worth investors (using registered investment advisors) portfolios in By comparison, institutional real estate investors typically have around 8.5% of capital allocated to real estate and Preqin suggests that target allocations are around 10.1% Why Invest in REITs, NAREIT, reit.com/investing/why-invest-reits, accessed 2 August Preqin Global Real Estate Report, Preqin, Tom Stabile, Can alternatives shelter US retail investors from a market turn?, Financial Times, 28 June 2018, accessed 10 July Preqin Global Real Estate Report, Preqin,

4 Figure 1: US REIT ownership by investor source Insiders 4.4% REIT or corporate 2% Other 5.2% Global funds 2.5 Active US MFs 15.3 US MFs 28% Retail 16% Passive US MFs 12.7 Institutional mandates 19% Pension or endowment or insurance 3.8% Hedge funds 3.6% US exchangetraded funds 11.7 Japanese MFs 3.8% Source: Citi In addition to the huge untapped market, two other emerging retail trends align particularly well to the basic attributes of property investment: 1. Retail wealth is primarily held by older generations. In the US, for example, the approximate 72 million boomers (people born from early-to-mid 1940s to mid 1960s) comprise 22% of the national population, but are estimated to hold 80% of aggregate net wealth. 5 While there will be a huge generational rollover of wealth in the next 15 years (estimated to be as much as US$24t), preservation of capital and income distributions to fund retirement will likely be priorities. 2. The way people save is changing. Assets are increasingly moving toward individual control notably in the seismic shift from defined benefit to defined contribution pension schemes. US-defined contribution plans hold an estimated US$7.7t of assets (2010: US$4.8t) of which US$5.3t sits in 401(k) plans. 6 It is estimated that approximately 25% of 401(k) plans offer a brokerage program or window to enable holders to choose where they want to invest. 7 Investment products focused on real estate and infrastructure that distribute attractive income yields, and preserve capital, while potentially providing a degree of capital growth to mitigate inflation, are likely to be in increasingly strong demand. 5. The Longevity Economy: Generating Economic Growth and new Opportunities for Business, Oxford Economics, Retirement Assets Total $28.0 Trillion in First Quarter 2018, ICI, 21 June 2018, ici.org/research/stats/ retirement/ret_18_q1, accessed 29 June Jeff Brown, Self-Directed Funds Not for All Investors, 19 March 2018, U.S. News, money.usnews.com/ investing/funds/articles/ /self-directed-funds-not-for-all-investors, accessed 3 August

5 Evolving structures to meet investor demand The real estate industry is evolving by making more use of both REIT and fund structures to better serve the needs of both retail and institutional investors. 1. Growth of REIT markets globally The number of countries introducing REIT legislation and size of the global REIT market continue to grow. Improved capital structures, better transparency and more robust capital allocation, since the financial crisis, have all contributed to a stronger product and greater adoption by investors. Stock exchange-listed REITs will continue to grow. Market cap globally stands at US$1.7t today, up 63% in the last five years, as the REIT concept has become a global brand around which more countries are organizing legislation. 8 Stock exchange-listed REITs will likely remain the investment vehicle of choice for many retail investors. Research has shown that net returns, standardized to remove reporting lags in unlisted real estate, favor REITs over unlisted real estate funds (11.39% vs. 8.22%), while volatility is only marginally lower for unlisted real estate. Correlations are high at 85%, which does not come as a surprise, given both investments primarily own and generate their return from the same underlying assets. REITs do a good job of providing property exposure and returns to investors that are prepared to hold investments for the long term. However, the downside of the liquidity provided by equity market listings is the ability to realize underlying property value at the exact point at which an investor wishes to redeem their holding. The daily pricing volatility inherent in an equity market listing can be problematic as it impacts the value of a security even if the underlying value of the real estate has not necessarily changed. This can, of course, also work to an investor s advantage. Figure 2: Quarterly total returns and standardized total returns, REITs vs. private real estate 40% Standardized total returns 9 30% 20% REITs Private real estate 10% Gross return % 10% 20% Investment cost Net return % Standard deviation % Correlation 0.85 REITs Private real estate Source: CEM Benchmarking, Asset Allocation and Fund Performance of Defined Benefit Pension Funds in the United States, , August SNL Financial, SNL XL Database, accessed June Standardized total returns remove the reporting lag and appraisal smoothing evident in private real estate. 3

6 2. Growth of externally managed listed REITs outside the US Listed REIT vehicles managed by external fund managers have proliferated globally. Externally managed REIT structures have long been considered suboptimal as a result of the lack of alignment because of perceived conflicts of interest and questionable fee structures. It is therefore somewhat surprising that many younger REIT regimes around the world have eschewed almost 30 years of modern REIT experience in the US and are significantly comprised of externally managed vehicles. As we highlighted last year (Internal vs. external management structures), the structure of many of these vehicles has evolved to reduce (but not eliminate) the gap when compared with their internally managed counterparts by addressing fee, conflict of interest and, where appropriate, liquidity issues by more closely mirroring successful fund models. Outside the US, many externally managed listed REITs give all types of investors the opportunity to access best-in-class management teams who previously have been exclusively available to institutional investors via their fund offerings. Alongside high-quality internal management teams, investors have a wide choice over the type of publically listed real estate product they want to access. Externally managed cross-border REIT structures are becoming increasingly common and Singapore is a particularly active market. Singapore is a large, transparent and liquid market with solid corporate governance. The city-state has long been positioned as a gateway to Asia with many of its REITs investing across the region. Recently, the Singapore Stock Exchange (SGX) has seen portfolios of US or European assets incorporated into REIT wrappers. Singapore is beginning to broaden its role from a regional hub for REITs making cross-border investments in Asia to a global REIT center. A number of factors are playing to this growth: East-to-west capital flows into real estate continue to increase, but for many Asian investors, the complexity and cost of undertaking deals in the US and Europe remains prohibitive. Investing in an SGX REIT is an appealing proposition to many small- and mid-size investors. A Singapore listing in partnership with an existing SGX manager combines attractive US or European assets with local market expertise and credibility. Pricing in Singapore remains favorable with US or European portfolios trading at a premium to NAV vs. notable discounts in parts of domestic markets. An SGX listing offers the appeal of annuity fees to be earned, and US or European managers can expect to receive an upfront lump sum payment from their Singapore partner to buy into the management vehicle. A Singapore REIT jointly managed by a US or European and SGX manager may be a springboard for deeper and more widespread cooperation in the future. 4

7 Non-traded US REITs and closed-end private equity real estate funds are a likely source of further listings. Non-traded REITs have an estimated US$50b 10 of liquidity events forthcoming, while many closed-end funds approaching termination hold high-quality portfolios that are likely attractive to Asian capital. Exiting via an SGX listing creates a liquidity event, which existing investors will value/require. However, it could also allow private equity real estate funds to transition, what are likely now mature assets delivering core type returns, into a structure that allows them to continue to manage the portfolio in return for annuity fees. For foreign REITs listing in Singapore, getting the structure right is key. North American entities seeking a REIT listing in Singapore must structure their REIT vehicles in a taxeffective manner in order to minimize the tax impact, and to maximize the distributions and valuations for the REIT. Structures typically utilize special purpose vehicles that are indirectly controlled subsidiaries of the US parent REIT and organized to qualify as US REITs. While the recently passed US tax reform has introduced new challenges to structuring these vehicles in a way that mitigates the tax impact, they are still viable investment instruments. Chris Johnston, Partner, Ernst & Young LLP 3. Greater use of non-traded REITs in the US In the US, we have not seen and do not expect to see externally managed stock exchange-listed vehicles gain in popularity. Internal management structures will remain the vehicle of choice. Instead, it is the presence of legislation allowing managers to sell non-traded REIT products that is facilitating additional access to property by retail investors. Non-traded REITs have existed for over 20 years. These were at their peak in 2013 and raised almost US$20b of new capital. 11 In 2017, fundraising had fallen to US$4.2b with the decline due to regulatory changes, perceived conflicts of interest, high-fee loads and lack of available liquidity. In recent years, this perception of the industry has been compounded by weak relative performance. 10. Non-traded REIT sales still low, but institutional sponsors should boost market, Tom Yeatts, SNL Financial, 12 July Robert A. Stanger & Associates 5

8 Figure 3: Capital raised in the non-traded REIT space, 2008 to H US$b % 62% 0 Source: Robert A. Stanger & Associates. While the sector has evolved in recent years, incumbent sponsors have been moving at a relatively slow pace in terms of creating greater transparency of valuation and changing fee structures to better align with investors through creation of multi-class fee structures. The entry of a leading global private equity real estate manager in late 2016 has been a catalyst for seismic change in the sector. New sponsors addressed known challenges by creating liquidity on a more frequent basis, (such as via Daily NAV REITs), introducing fee structures with trailing fees and performance-based incentives, side-stepping existing broker/dealer network channels by distributing through wire houses and organizing themselves in perpetual life entities. The result has been striking: 46% of all capital raised in 2017 accrued to one manager (H1 2018: 62%). Other global managers have since launched similar products. The success of the new model has contributed to a steady wave of liquidation events with an estimated US$10b of transactions in 2017, with another US$50b still outstanding. 12 Today H1 Legacy NTRs New model NTR (first entity) In the US, non-traded REITs offer an avenue for real estate fund managers to access the extensive retail capital that exists today. Aside from better, more transparent structures with improved liquidity, investors should also benefit from new tax laws that are favorable toward income distributions from REITs. The volume of capital raised in the last 12 months suggests retail investors are willing to accept a degree of illiquidity in return for access to best-in-class management through vehicles displaying high transparency, good governance, strong capital allocation and low-risk capital structures. Management of nontraded REITs by global private equity and asset management businesses also offers a different real estate investment proposition to internally managed REITs. We see this market evolving to target the significant volume of retail capital that exists today. A small number of products marketed through wire house and broker-dealer networks to primarily high-net-worth individuals Non-traded REITs have typically targeted retail investors through broker-dealer networks where the fragmented structure has contributed to the high upfront cost of these products. New model NTRs are being sold via wire house networks, which not only reduce costs, but also likely provide access to higher value investors. First movers that have gained early traction are likely to fill out wire house product rosters, which typically contain a relatively small number of similar products. A number of firms have launched new non-traded REIT products, while incumbent operators have increasingly moved to align their fee structures to the new model more typical of closed-end private equity real estate funds. Breaking into this market is likely already challenging with the expectation that a relatively small number of firms will dominate this fundraising avenue. The exception may be specialist or niche managers with bespoke products; this may include products targeting alternative real estate, digital infrastructure or broader real assets rather than purely real estate vehicles. 12. Bruce Kelly, Are non-traded REIT sales back from the dead?, Investment News, 12 July 2018, investmentnews.com/article/ /free/ , accessed, 8 August

9 Tomorrow Organizations fundraising products via pre-existing internal channels to retail investors Existing real estate asset management arms of pension and insurance funds are well placed to launch non-traded REIT products via internal fundraising avenues. By capitalizing new products internally to a level that makes them economically viable, these funds should then be able to replicate their existing institutional model with retail investors and drive further assets under management growth through a combination of both internal and external channels. The opportunity to leverage unique internal channels to retail investors will be a differentiating feature for this group. Table 1: Checklist for managers/investors considering launching a new model NTR product Market via wire houses and broker dealers (i.e., general partners) Market via internal fundraising channels (i.e., limited partners) Industry reputation Proven industry leader in a specific property niche Well established real estate/real asset management business Access to retail investors Strong track record of raising, investing and realizing institutional funds Access to wire house or broker-dealer network Direct access to retail investors via internal networks/products Ability to cross sell products to existing retail investors In-house capabilities Necessary skills and infrastructure to deliver fair value reporting Required infrastructure to seamlessly deliver investor communication to a large number of small accounts Equipped to manage retail fund flows Personal and professional skillsets needed to manage openended products 7

10 Future Greater use of technology to facilitate access to illiquid real estate Acquiring direct market real estate assets remains a highly nuanced investment activity, given the need to balance global or regional trends with local market knowledge. However, technology will streamline many of the processes associated with the asset class from capital raising and transaction activity to investor communication which often remain inefficient and hamstrung by the lack of liquidity in many parts of the market. In the short term, the non-traded REIT space is likely to benefit significantly from new technology as improved tools help bring a step change in liquidity. This will come from bringing together the current dislocated network of sponsors, inter-dealer brokers and investment advisors. Whether in a single platform and/ or through leveraging a combination of block chain, automated trading and clearing/settlement, it should be expected that increased liquidity will be the result. This will provide the financial flexibility, transparency and real-time pricing that investors desire. Technology is likely to have the most impact on onerous areas such as shareholder services and communication. These tasks typically use inefficient and outdated processes, which are poorly aligned to funds containing large numbers of investors and therefore remain an impediment to greater access to retail investors. Retail investors remain an under-penetrated but fast-growing capital source for the real estate industry. At the same time, the options available to investors continue to proliferate, as REIT markets around the world mature. Real estate managers are beginning to position themselves to capitalize on these significant tail winds. New investment structures in the public, private, domestic and international market offer a variety of mediums through which real estate managers can target new capital, expand their investor base, and grow their business. The dynamic REIT marketplace, evolution of technology and globalization of the wider real estate industry provides an opportunity for early movers to diversify away from crowded markets, capture capital flows that were previously unobtainable and position themselves to succeed in a real estate sector that is now very much mainstream. 8

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12 EY Assurance Tax Transactions Advisory Contacts EY Global Real Estate, Hospitality & Construction Leader Mark Grinis EY Global REIT Leader Mark Kaspar US REIT Tax Leader Dianne Umberger Ernst & Young LLP Australia Richard Bowman richard.bowman@au.ey.com Canada Tony Ianni tony.a.ianni@ca.ey.com France Jean-Roch Varon jean-roch.varon@fr.ey.com Germany Christian Schulz-Wulkow christian.schulz-wulkow@de.ey.com Hong Kong Harvey Coe harvey.coe@hk.ey.com Japan Koji Shikama koji.shikama@jp.ey.com Mexico Henry Gonzalez Duarte henry.gonzalez@mx.ey.com Netherlands Wiebe Brink wiebe.brink@nl.ey.com Singapore Sing Hwee Neo sing-hwee.neo@sg.ey.com United Arab Emirates Yousef Wahbah yousef.wahbah@ae.ey.com UK and Ireland Daniel Saunders dsaunders@uk.ey.com United States Chris Johnston Ernst & Young LLP christopher.johnston@ey.com About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com EYGM Limited. All Rights Reserved. EYG no Gbl BMC Agency GA ED None In line with EY s commitment to minimize its impact on the environment, this document has been printed on paper with a high recycled content. This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice. ey.com India Maadhav Poddar maadhav.poddar@in.ey.com Report contributors Analysts Henry Stratton henry.stratton@uk.ey.com Adam Fein adam.fein@ey.com