A Year of New Changes, New Rules and New Realities (Click here for a print version)  The economic recovery seems to be well under way. 2012 continued to be challenging for real estate investment managers, but there were positive developments none-the-less. Larger, established managers successfully raised capital for a number of funds, while smaller, more entrepreneurial groups managed to work through various alternative capital raising strategies. But what next? With new regulations, new demands and a slowly improving economy, what will real estate managers have to face from their investors, from government and from the markets? In December of 2012, NAREIM capital raisers and investor relations professionals gathered in Chicago to discuss our industry’s future direction. And though there were few absolute conclusions, there seemed to be a genuine consensus that our environment will not remain the same, and that alert participants in this market must be able to change along with it. The changing economy: Trends to watch In a discussion of the macro-economy, Joe Pagliari, Clinical Professor of Real Estate at the University of Chicago and Jim Costello, Managing Director and Head of Investment Consulting and Strategy, CBRE, discussed areas of worry on the horizon. Costello pointed to three trends to watch: 1. The health of the housing market, 2. The condition of a region’s state and local finances, 3. Quantitative easing and inflation. Pagliari affirmed the importance of housing. “The data shows that the health of the housing market is a leading indicator of the health of the commercial real estate market. As the single family housing market picks up, that should serve to pull the entire economy forward.” Housing has always been a significant part of the economy – comprising 4%-9% of GDP. Prior to WWII home ownership rates hovered around 40%. Public policy changes instituted after the war including the creation of Freddie and Fannie, interstate highway construction and the mortgage interest tax deduction were responsible for the rise in home ownership rates to a recent high of 70%. Since the housing bubble burst five years ago, home ownership rates have stabilized at 65%. Demographics are still very positive for housing. Based on population growth trends and family formations, there is a need for about 1,000,000 new units per year. The key challenge for investors is: what form those new units should take. Single family? Multi-family? What size? It is very likely that the answers to those questions will not be the same as they were ten years ago, but there is definitely a positive force for growth coming from the simple growth and demographics of the general population. The market also seems to have settled into a more reasonable band of pricing. There may be distress, but much of the distress discount is now more difficult to find. Pagliari observed, “If you look at Case Schiller data, today’s housing prices are about where they were ten years ago. I took a look at home prices since 1890 and then added a long term trend line to estimate where home prices should be today..are they still overpriced or have they fallen dis proportionally below long term trend pricing? “At this point, I don’t think prices are terribly over or undervalued.” Of course, the health of specific residential markets is very different at closer inspection. Pagliari developed a fascinating chart that showed the boom/bust price appreciation and depreciation of key markets. The middle curved line indicates all of the different combinations of price appreciation and depreciation that resulted in a net annual price appreciation of 2.4%, the annual rate of inflation. This would include housing in Denver, Portland, Seattle and Tampa. Any market below the middle curve experienced negative real appreciation. The top line indicates net annual price appreciation of at least 4% and includes the global gateway cities of New York, Boston, Washington and Los Angeles. “In general it is more difficult to build in coastal areas,” said Pagliari, “which might begin to explain why those markets experienced the greatest appreciation. There are implications for commercial real estate as there tends to be more volatility for suburban office tenant demand in the most volatile housing markets.” The financial health of state and local municipalities is likely to have even greater impact on the success of various investments, and Jim and Joe strongly encouraged the group to incorporate a deeper analysis of government finances in any risk assessment. What is the tax stream of the state? What percentage of state revenues come from income taxes? For example, in California, that number is 45% and the top 1% pay 45% of all income taxes. The numbers are similar in New York and New Jersey. An over-reliance on a small portion of the tax base is “a recipe for potential financial disaster” if the wealthiest residents move to low tax states, leaving even bigger gaps in state budgets. The challenge for local governments, of course, is not just revenue. Grossly underfunded pension systems in states like Illinois will challenge any governments efforts to balance the books no matter how much they raise taxes. When states cannot raise sufficient revenue the next step is to cut services, adding to the risk associated with owning real estate. Commercial real estate owners make an assumption regarding the availability of municipal services for garbage collection, snow removal and school quality. If these services adversely change, how will that affect real estate taxes, the willingness of tenants to lease space and ultimate real estate values? If tenants start to flee, assets will get re-priced. “I don’t think these risks have been priced in yet,” observed Pagliari. Costello concurred, “I do not think very many firms are thinking about the state of municipal finance issue in a structured way, they just assume the issues will get worked out.” If issues aren’t resolved, smaller, growth oriented firms may start to relocate and larger firms will continue to shift portions of their business to less expensive markets. Look at how much of the financial industry’s back office has already moved to states like Utah. Inflation isn’t here yet, and in some ways, that may be a problem. The fed has been buying long dated government securities in the hopes of lowering the cost of capital for borrowers so they will invest more. The greatest impact of this so far has been the lowering of lending rates for commercial property with fixed rate 5-year debt at 5% or lower. According to Costello, “these rates are helping firms carry assets, but it’s not yet having the total effect that was hoped for. There is not that much demand for money at the moment and that is keeping inflation in check.” “Inflation is actually a good thing for real estate,” Pagliari pointed out, “returns are highly correlated with inflation because rents will rise when markets are at equilibrium as they are today.” Marketing and Capital Raising Discussion: What is the new world order for fund managers? Seventy percent of the meeting participants are currently in the process of raising capital. Discussions ranged throughout the day on how to make sure those funds find the right investors and successfully close. A challenging process in the best of times, capital raising today requires more imagination, creativity and diligence than ever before. A few questions discussed during the round table follow. Can a fund be too small to be taken seriously by investors? The consensus believed that fund size needs to be appropriate for whomever the fund is being marketed to and the deal the size. As funds target who they reach out to, managers should be cognitive of any percentage of fund limitations. There are groups with caps of 3%, 5%, 10% and 50%. For example, a fund manager looking to raise a $100,000,000 fund might want to skip CALPERS because they will either take the entire fund or decline to participate. Markets seem to exist for funds of all sizes. A $75 million fund might include family offices and endowments on their prospect list. One manager pointed out, “In our $250 million fund we might have one or two $50 million investors, and that rules out all of the large investors. Then we are targeting the $10 million to $25 million investor to complete the fund.” Is co-investment a good idea? Funds usually use co-investment as a marketing strategy to gain a leg up in the fund raising process. “Increasingly, limited partners are asking for co-investment opportunities and think they have the organizational readiness where they can execute the strategy,” said one manager. “It can work, but it is difficult. For us it’s all about portfolio construction and how things fit with our other direct investments.” “A couple of other funds are pre-specifying the size and nature of deals that are eligible for co-invest and have a number of investors commit to a sleeve, but it is an opt-out sleeve. We are also getting inundated with inbound inquiries to put our capital along side sovereign capital. Making that work creates other challenges as there needs to be minority investors and it’s tough to make co-invest deals work from that position.” When you try to marry foreign capital with domestic capital it becomes more problematic because club deals are difficult to get approved even when investors are on the same wave-length. What are some good ideas for structuring marketing and strategy? Many limited partners have very structured multi-step due diligence policies beginning with a review of the marketing flip book and PPM. After internal review the decision is made to go forward or not or request a face-to-face meeting. Funds will try to circumvent the process, but for purposes of consistency, internal review protocols are observed. One investor noted, “What I love to hear upfront before the PPM and before the any due diligence begins are three things: What is your edge? How does that translate into performance in the past? And why should I believe it will translate into performance in the future. We need to hear something that would encourage us to spend our limited time because time is our most limited resource.” Staying in touch is important throughout the process, and even if investors aren’t ready to invest initially, they may be interested later. Things change. But it is essential that whenever you connect to investors, don’t just “chat” or “touch base”. They need to hear what and why – what has changed and why it makes sense to come into a fund now. What about third party capital raisers? The promise of introductions to pre-qualified prospects is alluring, but results may vary. Many participants in this meeting expressed reservations about the effectiveness of some third parties and were concerned about the cost. Many third parties require upfront retainers or monthly fees. They frequently do not make appropriate connections. Some attempt to control the direct relationships with investors until there is a first meeting. However, some funds have had success with third parties when raising funds outside of the United States. There is a good amount of European interest in US real estate, but the process is very slow. Third parties can be beneficial for filling gaps. One new fund had success with a third party because the group fulfilled a strategic need. The outside resource added credibility to the fund. They also provided unique strategies for helping market the fund. Also, because of their extensive experience, they were able to take the fund through the step-by-step process of fund raising. At the end of the day, whether going through a third-party or raising funds yourself, there seem to be few short cuts. Success here is a long-term process. Regulations Restrictions and Laws: What Should Capital Raisers Watch for Now? Regulation, compliance and oversight may be areas of the greatest challenge for investment management companies in 2013. Regulations are becoming more complex and unclear every day, and at times they even seem to be in conflict as the government is trying to solve multiple problems in the economy at once. Arthur Don, a Partner of Greenberg Traurig tried to bring some clarity to an often foggy subject during the day’s discussion. According to Don, “The easiest way to think about the JOBS Act is as the anti Sarbanes- Oxley Act.” President Obama signed the Jumpstart Our Business Startups (JOBS) Act for the purpose of increasing American jobs and economic growth by improving access to public capital markets for smaller and emerging growth companies. But it has the effect of softening some of the provisions put into place to protect investors. Two changes authorized under the act:

• The elimination of the prohibition on general advertising and solicitation¬†for private offerings
• Authorization to increase the maximum raised in a Reg A offering from¬†$5 million to $50 million

The SEC has issued preliminary rules regarding solicitations and final rules are still pending. Therefore, they have put this issue on the back burner for the time being. “Where does that leave us right now?, asked Don. “You can advertise offerings, but be very careful what you say on websites. You can say you are in the business of real estate management but if you are raising money you could jeopardize your entire offering and create enormous rights of rescission when investor money must be returned with interest if you say too much about your fund.” The uncertainty of the final rules is creating quite a bit of inconsistency in the market. Issuing press releases is an example. One company may have a history of issuing information to the media on an ongoing basis. Another company may issue a press release in close proximity to the time it is raising funds. The second company is on dangerous ground. For many firms the objective of advertising is to raise general awareness of the organization’s presence in the industry rather that promote the availability of a new fund. Image ads in upscale publications, such as the symphony program or business publication are acceptable places to run advertising—“just not when you are in the process of making a public offering,” cautioned Don. Websites are where the SEC typically finds the most issues. Some private equity firms take the position that their websites are created for the purpose of finding appropriate investments, not for seeking out investors. The types of information that the SEC frequently objects to are statements regarding the amount of assets under management, performance numbers, and lists of client investors in a fund. Any of these topics may have potential marketing value, but also can raise regulator ire. Don commented, “I suspect the SEC will get some pressure to define precisely what is permissible advertising and what is not permissible, particularly for performance advertising. When the final advertising rules are issued general anti-fraud and omissions standards will be specified. It is usually the omissions that trigger litigation. The standard is, did you need to add some information in order to convey a complete investment picture.” An example of an omission that commonly occurs in press releases might be an announcement of the launch of a new fund but fails to disclose that the financing has not yet been secured. Or, a real estate fund advertisement might include performance information through the end of the previous quarter, however a material event in the following quarter, like the bankruptcy of a major tenant, is omitted because it occurred after the end date of the reporting period. The courts could likely deem that as a material omission. Many firms print their PPM and think they are done. However, if anything changes over time, that information must be disclosed even if every detail in the PPM is accurate as of the date it was published. To do otherwise could expose the fund to charges of omission and potential litigation. The SEC has stepped up the number of audits it conducts, especially of recently registered investment advisors. Unfortunately, the auditors generally do not have a great deal of experience with real estate investment management firms and are more familiar with traditional portfolios of equities and fixed income securities. Knowing in advance what kinds of information the auditors are looking for can assist in taking some of the anxiety out of audits. Familiarity with exactly what is in your firm’s code of ethics and compliance manual is another important part of pre-audit preparation. Whether one is audited or not, until all these rules and guidelines are clarified, it certainly make sense for real estate fund managers to err on the conservative side. Do ad hoc reporting requests raise selective disclosure issues? Periodically investors will request a particular data dump to view the fund portfolio in a particular way. The request may be for property-level information, when aggregated portfolio information is included in the primary report. “I think the practical risk is greater in an open-ended fund, especially those owned by a public company,” said John Noell, a partner at Mayer Brown. In the course of receiving an ad hoc report the investor may gain insight into some really great news or a pending problems before all fund investors receive the same information. Selective disclosures can create an unlevel playing field and generate lawsuits from other fund partners who believe they were not treated fairly or equally. One possible approach is to post ad hoc reports on the firm’s website. Then the information is made available to all investors at the same time. Reporting, Governance & Transparency: How do these impact capital raising and fund structure now? “Reporting is very important to our industry”, said Evans Anderson, Director, Investor Relations, Colony Realty Partners, “it’s customer service and fulfillment for what we do for investors. More importantly, it leads to transparency, which is very important for successful fund raising” Peter Larsen, Principal, Hamilton Lane, added, “The Freedom of Information Act has helped to promote transparency across all sectors, providing the public with greater access to information, and a better understanding and insight into business operations. However, when information is not accompanied by the proper context or background, its ability to increase transparency is greatly diminished.” Today there are so many clear-cut basic reporting requirements that any firm that attempts to add anything that is different or “better” may just be adding more complexity or confusion. Some firms, for example, have been providing more asset level information in reports. What are REIS industry standards for reporting? Real Estate Information Standards (REIS standards) were developed through the cooperative efforts of PREA, the Pension Real Estate Association, and the National Council of Real Estate Investment Fiduciaries (NCREIF) to increase the consistency with which real estate investments are evaluated and reported. “REIS standards provide guidelines for a common reporting template of information that should and should not be disclosed…the problem is that not enough people know about these standards and very few are compliant with them,” said Jeff Havsy, NCREIF Director of Research. The reasons for non-compliance are somewhat varied. Ranging from lack of knowledge about them to a difficulty adapting a standard reporting methodology to different structures. Larsen pointed out, “every manager reports differently and one of the difficulties with standards is what do you do with a core fund vs. a value added fund with different strategies and different deal structures? Does it become a square peg, round hole situation?” Widespread adoption of REIS reporting standards is still off in the distance. “Not enough people know these standards exist,” Havsy said. “It is our job at NCRIEF and NAREIM to get the word out.” The LP typically specifies reporting requirements and currently the request for REIS-compliant reporting is minimal. The REIS standards continue to be modified and improved, but it is certainly worth investigating, understanding and perhaps even adopting. When selecting new managers, how much weight is given to a record of transparency? Transparency may be more of a requirement than a differentiator, so it won’t drive an investment decision. But that doesn’t make it anything less than essential. Managers have to demonstrate open communications, especially after the challenges faced by almost everyone over the last few years. It’s possible for investors to give a manager a pass for bad performance in the past – but only if they had an open dialogue regarding the cause problems and the steps taken to mitigate them. If a fund manager had poor performance having candid discussions about the challenged assets and what was learned can have a positive impact. During the downturn managers who were upfront about what they were doing to work through their problems and demonstrated they made client interests the top priority were rewarded with higher levels of loyalty once the market turned. According to one investor: “Bad performance is excusable but bad behavior is not.” So, What’s Next? For those engaged in raising capital and communicating with investors, the year ahead seems to have much in store.

• As a new growth cycle continues to evolve, and the profiles and priorities of investors¬†change, there will be ever more demand for clarity, compelling strategy, transparency,¬†and flexibility.
• Regulations will become clearer, but we will have to be very careful until they are¬†completely in focus.
• More data, more standards, and more technology are around the corner.

Real estate investing is not the same as it was before, nor will it remain the same as it is now. Success will be dependent on investors’ ability to adapt, to persevere, and to help their clients find yield in turbulent waters.