At the end of December 2008 the number of real estate fund units in Luxembourg stood at 137, which represented a six fold growth on the number in 2004. In the same period, the value of net assets under management almost increased eight-fold. Not everyone is agreed on the reasons for this impressive surge. Alison Macleod, head of Real Estate at KPMG explains that the evolution of the Luxembourg fund law from 1988 to 2007 has created an attractive, tax neutral, environment for international investors to establish real estate funds.
"The attraction of Luxembourg is that its reputation in long only funds when coupled with its clear legal structure and sympathetic but firm regulatory environment has created the certainty that long-term institutional investors require to establish real estate funds." Macleod also praises the effective marketing of the Luxembourg real estate and alternative investment options by Alfi and Luxembourg for Finance as well as the major legal and professional services firms.
Others, such as l'avocat à la Cour, Me Michael Dandois from law firm Dandois & Meynial, believe the gold rush for real estate investments was a phenomenon that can be attributed to market forces - that there was simply a demand that had to be met. "Despite all sympathy I have for Luxembourg, I don't believe the explosion in their popularity was due to us putting in place any intelligent or innovative instruments. I think it really followed the movement and impetus launched by the bull market of 2002 and 2003." This combined with a trend to look for alternative products and the rise of the stock market, as well as a movement to look at the speculative value of real estate. "So subscribers became interested in structured products based in real estate," says Dandois.
What they can agree on is that since the crisis started, the market has faced severe problems. Two scenarios in particular appear to be playing themselves out at the moment. Firstly, real estate funds established in 2003 or 2004 whose financing has now come to term and are seeking to refinance, face a problem with a lack of liquidity.
"If you are a long-term investor in real estate funds, you are faced with decreasing NAVs so you have less income and will have a real challenge to structure your business and maximize efficiency," says Ingo Bofinger, head of relationship management for alternative investments at LRI Invest Luxembourg. Macleod explains that the current financial crisis is causing distinct problems for real estate funds.
"The drop in real estate values has significantly affected funds that have significant leverage. Most banks that have lent to these funds have imposed covenants that require loan to value ratios that will require additional capital to restore the balance of the find. Many funds are breaching these covenants whilst others are unable to service their existing debt." Liquidity is certainly posing a huge problem, says Bofinger. He explains that a recent meeting with bankers revealed that there are some interesting projects on the market, but there is no financing. Investors are being cautious because they don't want to buy at too high a price. "But I think that maybe new financing models will arise, or new financing partners will emerge. For example, insurance companies might be in a position to provide loans," he says optimistically.
Macleod highlights the issue that the lack of an immediate solution to either the breach of covenants or the inability to service their debt is affecting the annual audit process. "Auditors are questioning the real estate funds as `going concerns, because without certain future financing, funds will have to be closed or restructured with significant losses for investors and a further depression of real estate prices as distressed sellers have to liquidate their real estate investments." She praises the work done to date by the banks, the promoters and their professional advisors in working through the issues and coming up with solutions that do not exacerbate the current problems. "We will not see a significant relieving of the problem until lenders and investors are confident and willing to return to the property sector," she says.
QUALITY MATTERS
But Macleod is confident that the market will recover in the next eighteen months and is aware of cash rich entities that are looking for long term bargains. "Providing the liquidity is there, I believe the market will correct itself and that real estate funds will be an attractive long term and successful investment class for institutional investors. This crisis has shown that investors looking for short term gains should not consider real estate investments, because when we move into recession or depression, the liquidity dries up and the sellers are required to accept fire sale' prices." Bofinger says that the secondary market is becoming more interesting as institutional clients are forced to sell shares in funds due to the nominator effect.
"This is creating great opportunities for equity buyers who can purchase at a huge discount, but they must have the power to last the next few years while the fund gets to work and develop projects. Then they can enter a new transaction phase," he explains.
Bofinger thinks that one consequence of the crisis will be the disappearance, for a long time, of larger funds of the Blackstone ilk. The trend will now be towards funds that follow a core strategy, with moderate leverage, investing in income-producing properties with a really strong tenant covenant. "We are really seeing a return to old values - location, tenant quality, quality of the building are important," he says. Dandois agrees. "In real estate there are three things that count - the quality of the building, the quality of the tenant and the quality of the rental contract. You must remain true to the fundamentals, and that is that you have invested in a building. There is a danger of being caught up in euphoria and forgetting the very fundamental questions."
VALUATION STANDARDS
One question that is of particular interest to real estate funds is valuation, which is especially difficult in the current market which has shown very little sign of movement. Indeed, at the end of last year the Royal Institution of Chartered Surveyors (RICS) said it recognized that "the valuation process is extremely difficult when there is a greatly reduced volume of reliable sales evidence." However, the RICS issued guidance to maintaining valuation standards even in uncertain times. "It is not appropriate for reports to feature caveats or qualifications which would cause the client or auditor to question the validity of the valuation, or to qualify a valuation report."
Dandois agrees that valuation has to be conducted according to arm's length principle, for fair market valuation. But Bofinger warns that at the moment players are not particularly interested in receiving the market value at a specific time."They want to see the value on a long, consistent basis," he says. "Investors should realize that they don't have to buy, or at least should only buy at a good market price based on a sustained market evaluation."
With new regulation also likely to be introduced, Dandois warns that fund administrators are facing increasing costs. "Since 9/11 we have insisted on the `know your customer' principle, which already involves excessive cost," he says. "We have to be careful that we do not kill the product by over-regulation and a disproportionate accumulation of costs. I am convinced that the market can regulate itself." Through her contacts with Alfi, Macleod highlights the issue of regulation. "I expect that we will see new regulation, and that there will be much `soul searching' as to how we can reduce the risk of this happening again. I am encouraged that there has not been a 'knee jerk' reaction to this unique crisis and that there will be much careful thought that will not undermine the value of the Luxembourg real estate funds."
Bofinger thinks that the whole question of tighter regulation is being introduced to appease the public and that the industry already has good controls in place. What he does agree with is that products need to be simplified. He cites customer pamphlets from 1974 that consisted of just a few pages. "Now you have prospectuses that are as thick as a book. They are much more detailed, but investors won't read them. I don't think increased regulation will really help. What is important is transparency and to have open dialogue with the client."
As for the future of the local real estate investment funds market, Bofinger suggests that Luxembourg is going to have to start providing some mid-office services. "In terms of the real estate fund industry this could be reporting. I think it is a trend that fund managers will outsource more and more reporting to third parties - which could be an opportunity to create a new product to sell to fund managers, to create good standards in reporting." Bofinger also wants to see the Luxembourg authorities make a big effort to improve local infrastructure, not only in terms of roads and airline and train connections, but also the international schools and other services. "This is important in order to attract people and thus attract money" he says.
Vehicles
SIF SUCCESS
The Specialised Investment Funds (SIF) law of February 2007 has proven extremely successful with real estate investment funds. As of October 2008, 76% of real estate fund units were under SIF law, with 53% combining that regime with the Fonds Common Placement (FCP) vehicle. • D. R.
Market prospects
GERMANY RULES
European property markets remain the favourite target of the majority of real estate investment funds. Four German cities rank in the top 10 investments prospects for 2009 (Munich, Hamburg, Berlin, Frankfurt). • D. R.