How Can We Limit the Effect of Real Estate Cycles on Closed-Ended Funds?
By Terence Bundy
NAREIM Fellow, UNC Kenan-Flagler MBA ’16
Terence is a Class of 2016 MBA student at UNC Kenan-Flagler concentrating in Real Estate and Corporate Finance. Terence is currently the Lead Manager of the Kenan-Flagler Business School Foundation Real Estate Private Equity Funds and spent his summer internship at AEW Capital Management. Prior to attending Kenan-Flagler, Terence spent a combined eight years working at Mission Capital Advisors, Merrill Lynch, and Deloitte & Touche.
I started my career as a CMBS securitization analyst in 2005 and that experience led me to believe that all pro-forma rents would be achieved and that real estate values would increase forever. Like most professionals in the industry, including tenured professionals, I didn’t realize that I was starting my career at the peak of one of the most robust cycles the industry has ever experienced. While fund managers can analyze the empirical data showing how real estate markets move in cycles, no data or rule book exists on how to effectively time these cycles. This timing issue is perhaps one of the biggest challenges facing closed-end real estate funds. Because cyclical forces have such a dramatic influence on fund returns, I believe there are several important factors to consider when investing limited partners’ capital via a closed-end vehicle. Although there are countless conditions within a standard closed-end fund partnership agreement that attempt to mitigate downside risk, I want to focus on two strategies. I believe that: (i) marking assets to market and utilizing a separate, longer horizon fund vehicle to acquire the assets and (ii) including language in the partnership agreement that permits more flexibility for extensions during bona fide market downturns, would minimize the use of liquidation scenario valuations and enable managers to more appropriately dispose of assets. These strategies are likely discussed, however, making them more explicit in the partnership agreement and having continuous dialogue with investors would improve the overall success of closed-end funds.
Research proves that throughout history there have been distinct and identifiable real estate cycles such as those ending with the Savings and Loan crisis, the dot-com bubble, and the Great Recession. Specifically focusing on value-add or opportunistic real estate funds, where the majority of the return is achieved through asset appreciation and pricing at disposition, timing investments within these cycles is vital.
When a closed-end real estate fund is raised, the vehicle’s overall performance is heavily influenced by what point of the cycle the fund is raised and dissolved. Acquiring or selling at peaks or valleys will greatly influence the returns of both individual assets and the fund.
Professionals in the industry are aware of the effect of market timing on investments, but can’t seem to grasp how to adjust the playing field. As Nick Benson from Latham & Watkins stated in the July 23, 2015 Private Funds Management article titled, “Interested in evergreen funds? Consider this”, “Some funds, raised in the early 00’s on the traditional private equity model made any number of perfectly good investments for which satisfactory exit transactions did not arise. With the onset of their term expiration, these funds have simply run out of time. The result is either liquidation or restructuring of portfolios that ideally would have been held for longer in order to fully realize their value.“ The limited flexibility of closed-end real estate funds sets managers up for problems during hyper supply and recession markets. To counter this, a proactive manager could either institute my suggestions above or complete more comprehensive due diligence upfront and acquire assets that will perform even in the face of a downturn due to their location, tenant quality, or other intangible factors.
Investors typically do not find themselves in a strong negotiating position when they are a motivated seller or buyer. The typical finite investment and hold period of a closed-end real estate fund can inadvertently cause this weakened negotiation position because acquisition and disposition activity become dependent on fund timing versus capturing maximum value. Returning capital to investors, because suitable investments could not be made due to market forces, often results in less effective future fund raising activities. During the harvesting period, managers will also have difficulties appeasing investors if they have to rely on the use of multiple fund extensions to liquidate the portfolio appropriately. While these valuation and timing constraints are inherent risks of a fiduciary, it highlights the impact real estate cycles have on closed-end vehicles and the negatives of being a motivated buyer or seller.
Akin to real estate fund managers all over the globe, I am personally facing this timing and cycle dilemma as the lead fund manager of three Kenan-Flagler Business School Foundation Real Estate Private Equity Funds (“KFBSF Funds”). The closing of Fund III, a closed-end vehicle serving high-net-worth limited partners, occurred in early 2015. My classmates and I are tasked with deploying capital in value-add and opportunistic investments at a time when the consensus believes pricing is high. Depending on who one asks, there are varying opinions on where we are in the cycle, with one attendee of the NAREIM Executive Officer Fall Meeting profoundly stating, “I don’t know what inning we are in, but what I do know is that we are asking the question.” As we are not permitted to amend the terms of our agreement or acquire assets from previous funds, several ways the KFBSF Funds managers are addressing the deployment of capital during Fund III’s investment period, while being cognizant of the market cycle are: (i) focusing on sponsor strength and track record; (ii) completing conservative underwriting and paying close attention to downside scenarios; (iii) investigating potential exit opportunities in the market; and (iv) aligning Sponsor hold periods with our fund life. Lastly, from a legacy fund perspective, we are focused on our fund mandates and attempting to exit investments while extracting as much value as possible for our limited partners.
In a typical closed-end fund structure, after the investment period concludes, the harvesting period begins whereby managers are constantly surveying potential asset dispositions. Subject to available extension options, normally totaling two or three years, the fund term expiration occurs after the conclusion of the harvesting period. During the waning period of the original fund term or extension options, managers can become motivated sellers regardless of the market cycle timing. I worked with these motivated sellers firsthand in my role as a commercial mortgage loan sale advisor from 2008 to 2014. Primarily focused on evaluating and selling distressed commercial mortgage whole loans, I saw government agencies, special servicers, commercial banks, and private equity funds selling assets during the recession due to regulatory bodies and fund life expirations. While many fund managers saw their value destroyed due to forced sales, investors that were permitted to adjust their strategy and delay dispositions or make acquisitions, were wildly successful. This timing issue will continue to be a delicate balance and fiduciaries could focus on extension terms or buyout clauses to achieve stronger downside protection for their investors.
There are clearly positive and negative attributes to the various styles of real estate investment vehicles available in the marketplace. In order to counter the negative effect of completing acquisitions at the top of the cycle or liquidating assets at the bottom of the cycle, fund managers need to not only focus on smart underwriting but also work to obtain better extension and buyout terms with their investors. My real estate mentors and teachers, as well as market pundits, always talk about investors’ short memories. I saw the peak of the last cycle in my first real estate role and the thundering collapse in my second role. As we move forward in the current maturing cycle, I can only hope managers are avoiding “priced to perfection” transactions through diligent underwriting and by paying close attention to their vehicle’s investment and liquidation timing constraints. Given proper management, closed-end real estate funds will certainly be better positioned to avoid the worst part of a downturn, which we cannot time, but we know is coming.← C&I 2015 Report: What Does Capital Want? NAREIM FY 2015 Audited Financials →