Global market outlook 2015
Trends in real estate private equity
Contents
Introduction
We often come across the word “disruption”; so much so that it has
outgrown the need for explanation. When people say that traditional
media is being “disrupted” by social media platforms such as YouTube
and Twitter, it is quite clear that the industry is not facing small-scale
quaking, but rather off-the-charts seismic activity that is tearing
down the old order. The same applies to traditional brick-and-mortar
establishments, such as schools, banks and retail shops, which are
being disrupted by online classrooms, mobile payment systems, and
all varieties of consumer products that are now only “one click” away
from your front door.
Coming of age in real estate fund operations
4
Introduction
2
Fundraising: green shoots
7
Real estate M&A: spin-offs and mergers and acquisitions
9
Global deal flow: it’s a small world
12
Now: European Asset Quality Reviews; transactions to follow
18
BEPS and other tax updates
20
Trends in fund reporting
23
Outlook
27
Contacts
29
3
Trends in real estate private equity |
The real estate industry is being disrupted by a number of new
economic and social influences. Businesses are leasing less office
space to reflect “leaner,” more streamlined operations. Retailers are
looking for giant distribution centers to serve customers who expect
convenient and immediate access to their products. Millennials
and baby boomers want “live, work, play” environments, instead of
suburbs with large yards and two-car garages.
Even real estate investors have caused disruption in the fund space by
demanding more and faster information about who is allocating their
capital and where.
This year, EY’s Trends in Real Estate Private Equity report takes a close
look at how and where the real estate sector is experiencing its own
disruptive tremors. One area facing noticeable and significant change
is fund administration. Several recent, high-profile administration
liftouts point to a shift from early stage outsourcing experimentation
to an area of growing maturity, with administrators offering more
sophisticated, comprehensive and reliable services to real estate
fund managers. Development may still have a way to go, as many
administration platforms still function as adapted hedge fund or
mutual fund models. But players in the space have clearly started
proving their value and have an increasing number of large funds
convinced that full-scale back and middle office outsourcing is the way
forward, even if the learning curve remains steep.
A rush of foreign capital is also having a disruptive effect on real
estate pricing and opportunities in global gateway cities. As a result,
spikes of activity are popping up in markets and asset classes that
have lagged in recovery until now.
Beyond these major trends, this year’s report also takes a broad look
at issues affecting the real estate fund environment. In particular, we
focus on:
Global deal flow – Exploring the key real estate markets where money
is flowing in and out, around the world, including German institutional
investors’ love for the German retail sector, Brazil’s over-supplied
office markets, how Israeli bonds are helping US companies raise
funds, Asian investors’ increased focus on domestic markets and how
India’s new government may bring back foreign real estate investors
Reporting – Examining the ongoing debates and a series of transitions
that are in the pipeline, current reporting standard frameworks,
including the convergence of global frameworks, and the European
Securities and Markets Authority’s Guidelines on Alternative
Performance Measures and its push for stricter definitions on
performance metrics and “fair value” reporting
Tax – Dissecting the Organisation for Economic Co-operation and
Development’s (OECD) base erosion and profit shifting (BEPS)
program, including how it affects funds that are based in one
jurisdiction but doing business in another and the types of “future-
proofing” options funds are exploring amid changing tax treaties
We also review fund governance, the fundraising environment and
continued consolidation in the real estate fund sector.
Many of the themes addressed in this year’s report are causing
widespread changes to the real estate investment environment and
how fund managers are doing business. It is important to bear in
mind that real estate is, after all, crucial for society and industry to
grow effectively and reflect evolution. These transformations are
unsettling, as the retail sector in particular is discovering; yet, its
innate ability to adapt is the reason why it remains relevant and in
high demand.
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| Global market outlook 2015
1
Coming of age in real estate
fund operations
There has been an increased
interest in back-office operations
outsourcing among real estate
fund managers proving how
far interest in real estate fund
administration has come in the
industry.
Shaking the cost burden
It isn’t that the sophistication of fund
administrator platforms has improved so
significantly for real estate. In all, it is still a
fairly immature market. Rather, real estate
funds have been feeling the squeeze on costs
and management fees and are beginning
to evaluate something they see as non-
strategic. Momentum is now building, with
several other high-profile liftouts on the
books, a number of other large real estate
fund managers are looking to move in the
direction of outsourcing.
5
Trends in real estate private equity |
Top five items investors look for in operations
Best-in-class
technology
Range of
services
provided
Client
service and
expertise
(72%)
(67%)
(62%)
Flexibility to
customize
services
(42%)
Ability to
handle
complex
investment
structures
(19%)
Differentiating from competitors
While cost management may be a driver, funds considering or
pursuing such a significant move are also making a strong statement
about their vision for the future of the business. Outsourcing
isn’t a simple exercise in improving operational efficiency or cost-
effectiveness; it requires that everything related to business strategy
be separated from all other functions, particularly replicable
processes like accounting, investor servicing, property-level data
collection and standardization, and reporting. The message this sends
to the market is that fund managers understand clearly what their key
value to investors is, and they should be trying to optimize around it.
There also seems to be a shift in fund manager attitudes toward the
cost of these large-scale projects. Whereas several years ago, most
managers were unable to justify the cost of a major outsourcing move
because of the lack of most administration platforms’ capabilities,
many now appear more willing to bet on long-term cost savings,
in spite of the significant up-front price tags. It remains to be seen
whether managers with the flexibility in their fund documents will
elect to pass on third-party administration costs to their investors, as
most have been reluctant to do so thus far.
Understanding outsourcing costs is difficult at this stage, as no clear
benchmarks have been set and the models used by the various
administrators have generally been inconsistent. The industry is
still testing too many different approaches. For example, there are
a number of fund administrators that have established models for
private equity or hedge funds and are working to adapt these to the
real estate sector. These models have proven best equipped to handle
large-scale outsourcing transactions so far, as most are accustomed
to handling fund and portfolio-level services. Tackling asset-level
services, however, is often completely new territory for these
“above the line” administrators, and many are still trying to recruit
the right personnel to design and test these services. The learning
curve, therefore, continues to be steep. Approaches for adding
asset-level services, for example, property-level data collection and
standardization, equity reconciliations and other services to existing
platforms, are also extremely varied. Indeed, the reason the industry
hasn’t seen more asset-level outsourcing recently comes down to
administrator capability, not fund manager demand.
On the other end, some asset managers and real estate services
providers have taken on a different approach by trying to expand into
full-service reporting and fund-level accounting. The convergence
between these two approaches will eventually solidify best practices,
but this is likely several years away.
Otherwise, the fund administration space hasn’t experienced any
significant false starts that would damage its reputation or stall
the momentum of outsourcing or future demand for real estate
fund services, but the industry is still in its nascent stages. So far, it
appears that fund managers who are coming around to the prospect
of significant long-term cost savings and improved operational
efficiency are willing to be patient through the development and
experimentation process.
Source: EY survey
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| Global market outlook 2015
“Bread and butter” outsourcing
If the recent examples of full-scale liftouts have been making the most
noise in the fund administration space, they are still far less common
than piecemeal outsourcing. This is especially true in the boutique
and midsize fund space, where large-scale outsourcing deals are
viewed as unnecessary and there has not been significant market
demand. In fact, the most sophisticated real estate administration
platforms tend to be concentrated in this segment of the market.
They have remained here in spite of demand from larger funds
because these providers do not have the capability of scaling up to the
level that the multibillion dollar fund managers require.
Boutique and midsize service providers are proving to be in especially
high demand in Europe. With the deadline for registration under
the Alternative Investment Fund Managers Directive (AIFMD) now
past, a number of mid- to large size managers looking to build out
pan-European platforms are taking a closer look at which back-office
functions can be outsourced to help them streamline their operations
and bring down costs. Most are motivated by concerns that intense
governance and reporting demands will draw too many resources
away from executing deals and managing assets.
Regardless of what level real estate fund managers are operating on,
the overall maturity of real estate administration platforms is still a
ways off. Most of the capabilities exist, but they are not yet offered
by one shop. When they are, back- or middle-office functions should
never be entirely outsourced. The lion’s share of the ‘repeatable’
aspects of the core processing functions can be designed and
managed by the administrator, but the management and control
elements necessary for a real estate fund must always be handled
by the manager. Additionally, while an administrator can take over
data collection and financial report generation, it will always come
down to the fund manager to verify that these services are producing
accurate results.
Key issues and concerns in the market — property manager and investment manager
Source: EY
Cost leakage – costs being passed through to
asset managers incorrectly
Executive management concerned with managing
reputational risk
Increasing concerns that the property manager’s controls
are not functioning properly
Lack of controls around cash management
• Bank reconciliation approval
• Invoice approval
Duplication and/or inactive vendors in the vendor list
Inadequate property and tenant insurance as required by
the management and lease agreements
Management fee errors
Improper lease management
• Rent roll inaccuracies
• Non-compliance with the lease agreement
• Missing documentation in lease files
Property manager
1
2
3
4
5
Lack of confidence in the quality of the data included in
reporting from the property manager
Investment manager
Lack of visibility, operational transparency and
financial processes at the property level
1
2
3
4
5
Because real estate is a local business, the importance of developing successful partnerships with local market players is crucial for
real estate fund managers. The managers that recognize investor demands are trickling down to the property management level are
proactively reviewing their partners’ existing controls and systems. Listed below are some of the key issues and concerns.
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Trends in real estate private equity |
Fundraising: green shoots
With the amount of global
capital looking for real estate,
mid-market funds must be
wondering why they cannot seem
to get a break. The fundraising
environment continues to prove
challenging for many funds in
this segment of the market.
Many have been fundraising
consistently for the past several
years and are increasingly turning
to third-party placement advisors
for help in building new investor
relationships.
2
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| Global market outlook 2015
The main challenge for the mid-market is that most investors, in spite
of their real estate interest, have continued to be intensely selective
of the funds they partner with. In addition, investors are cautious
about unfamiliar funds; most will opt to re-up with their existing
managers rather than explore new relationships. Additionally, the
vetting processes of those who do explore new relationships can be
extremely slow.
Unsurprisingly then, the field of players in the mid-market has not
grown significantly in recent years — a trend that will likely continue
for two to three years. Interestingly, management teams that have
difficulty raising capital don’t sit still, as evidenced by many high-
profile players being picked off by several large real estate fund
managers. What differs between current consolidation activity and
the wave of activity that previously hit is that managers are engaging
in consensual deals, and many more are quietly expressing their
interest in finding a buyer.
This trend is a clear reflection of market improvement. Many of
these managers now feel they are no longer in survival mode; rather,
they may choose whether to sell or not. Those opting to sell may
be motivated to turn their businesses over to fresher hands, having
survived the financial crisis. Others may be looking to expand their
platforms and capabilities or to engage in new markets. In the long
run, this type of consolidation will strengthen the fund space and
improve the overall health of the mid-market.
As for midsize players trying to hold their own, if there is any
consolation for their persistent fundraising struggles, it is that the
environment for launching new funds is equally difficult, particularly
in Europe. Unlike in the US, the European markets remain cautious
and have not yet developed a strong appetite for new, specialist
and boutique offerings. In spite of immense competition for core
and core-plus deals, most investors are not yet willing to test small
allocations for new, unique strategies. However, we expect this trend
to change quickly as investors start to receive capital back from some
of their larger manager relationships.
Those that have been successful with fundraising, whether they are
boutique or midsize players, have tapped into a new level of creativity
to do it. Many players now offer service “menus” to their investors,
including separate accounts, club deals, and other options such as
mini-funds structured as co-investment vehicles. Another strategy is
demonstrating a strong deal pipeline by negotiating buyer exclusivity
on individual assets or portfolios. This proposition is attractive to
investors, given their difficulty in placing capital. Nevertheless, only
the most skilled managers have been able to hold down deals long
enough to pitch for capital.
One bright spot in the fundraising world is that equity funds are once
again in vogue, both in the US and Europe. In Europe, this trend
lagged far behind the US, and debt funds secured the largest share of
capital over the last two to three years. This year however, investors
everywhere have shown appetite for risk, which has translated into
renewed interest in equity funds. Those being the most successful
have core-plus and value-add investment mandates and investors with
a tolerance to reach for higher risk-adjusted returns.
Debt funds, meanwhile, have not fallen out of favor. In the US, the
market is very well developed, while in Europe the debt fund market
has matured. The scope of offerings in Europe now spans beyond
senior debt into junior and mezzanine levels. This will continue to be a
key area of opportunity for funds in Europe, given the amount of real
estate refinancing still required, and in the US market for the large
volume of low maturities originated 7-10 years ago.
Top five influences on capital raising
Although change in the industry is constant, some things stay consistent over time.
1
3
2
5
4
Defined and differentiated investment strategy
Experienced team
Strong alignment of interest with investors
Demonstrable track record
Clear capital araising strategy
Source: EY
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Trends in real estate private equity |
Real estate M&A: spin-
offs and mergers and
acquisitions
The recent surge of mergers
and acquisitions (M&A) activity
appears very reminiscent of
2007, after several consecutive
years of improving confidence in
the economy and deal markets.
M&A activity is driven by a desire
for incremental growth, strategic
merit of transactions, and the
availability of debt and equity on
favorable terms. All three of these
elements are currently present,
which has allowed for healthier
and more robust deal markets.
The volume of global capital
chasing real estate opportunities
has contributed to recent M&A
activity. In the US, for example,
roughly 11% of 2013’s US$355
billion in property deals were
made by foreign investors; foreign
investment is expected to surpass
2013 levels in 2014/2015.1
The difficulty this capital influx
has placed on deal sourcing for
fund managers has driven many
of them to look for new ways
of expanding their real estate
portfolios. And favorable market
conditions have given them the
confidence — and risk appetite —
to do this.
3
1. “Cross Border Capital Tracker”; “Year in Review,” Real
Capital Analytics, January 2014.
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| Global market outlook 2015
Real estate investors are more confident in pursuing the acquisition
of real estate operating platforms with the objective of owning the
underlying real estate and not necessarily operating the platform as
an operating business.
Management team
credentialized
with investors
Ability to access
existing and new
sources of capital
Management team
that is complimentary
to the culture of the
platform
Expanded growth
prospects in new
regions
Global investment
solutions
Expanded
distribution
capabilities
Integration of back
and middle office
New product
development
New, broader
access to deal flow
New relationships
and expertise
Top items to consider when acquiring a real estate investment platform
The challenge for traditional real estate investors is how to vet these
deals, particularly under an increasingly high-speed diligence period.
Real estate investors may be familiar with underwriting individual
properties, assessing value and modeling cash flows, but these kinds
Source: EY
of transactions cannot be solely dissected as real estate portfolio
acquisitions; there are other factors to weigh when buying an entire
platform. These include assessing the appropriate level of overhead
required to operate the properties as well as potential commitments
and off-balance sheet liabilities of the business. Also, the parties may
encounter discrepancies in pricing expectations if a seller prices itself
as a stand-alone business while a prospective buyer prices the deal as
the acquisition of individual properties.
For company acquisitions, the real estate portfolio valuation is
obviously a critical part of the due diligence process when the
real estate is key to the strategic rationale of the transaction. Yet a
top-down businesses assessment is also crucial to ensure the property
valuation does not understate or overstate other key items on the
balance sheet and the legal form of ownership.
These are important considerations, given the opportunity for real
estate M&A deals may increase in the near future, particularly in
the real estate investment trust (REIT) space. Many of the larger US
REITs are facing market scrutiny for their wide-reaching investment
strategies, and they are responding by pulling back their core
strategy and selling everything else while taking advantage of very
strong pricing generally seen in the current market. Spin-offs in a
privatization transaction will present large portfolio opportunities for
fund managers capable of writing large equity checks.
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Trends in real estate private equity |
Another interesting development on the M&A side of the market is
the emergence of new players in the real estate space. For example, a
number of financial institutions that historically have not been direct
investors in real estate are looking to expand to new platforms, taking
advantage of their base-level knowledge of real estate from their
lending or other investment activities. These new players are not only
diversifying the M&A landscape, but also making it more competitive
for existing real estate funds and investors.
Whether the run-up in M&A activity will eventually outpace the
2007 peak is not yet known, but a key difference is the discipline
with which capital is chasing opportunity and expanding into new
territory. Capital marked for the real estate markets may once again
be abundant, but the way it is channeled continues to reflect lessons
learned since the financial crisis.
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| Global market outlook 2015
The amount of global capital
currently earmarked for
real estate investment is
extraordinary. With few
exceptions, institutional investors
are competing for core assets in
global gateway cities. Whether
they are Canadian pension funds,
sovereign wealth funds, or Asian
and Middle Eastern high-net-
worth investors, all are looking
for long-term assets in these
markets.
4
Global deal flow: it’s
a small world
13
Trends in real estate private equity |
The effect of foreign investment on the availability of opportunities in
these markets has been enormous. In London, there are a significant
amount of foreign cash buyers in the housing market, and in the US,
the surge of capital into primary cities that elevated competition for
deals has not deferred investor appetite.
This bodes well for the industry at the macro level, but it has also
created new challenges for private equity players trying to allocate
funds or hit return targets. These funds are rarely present amid
New York’s and London’s core bidding wars. More can be found
searching for yields in markets and asset types that fall farther along
the risk curve.
In the US, the uptick in interest outside of gateway markets is
beginning to create heat in some well-known secondary cities —
ones deemed “secondary” for their rental rate growth prospects
rather than their economic diversity or viability. Examples of
these include Atlanta, Seattle and parts of southern Florida.
Investors engaging in these parts of the country are betting on
increasing demand for high-quality assets and have pegged their
chances for a high-yield exit.
Private equity interest in development has also picked up, with
a number of funds backing new hotel and distribution space
construction in particular. On the industrial and distribution side, a
surge in new construction is underway in southern Florida as a direct
result of the ongoing Panama Canal expansion.
New development in any asset category outside of multifamily has
not yet reemerged significantly in secondary markets, however.
These still appear to carry too much risk for most real estate players.
Equity requirements on new projects remain between 50% and 65%
on average, and most lenders require some form of construction
guarantee.
On the debt side, the industry is seeing strategy diversification,
particularly from private equity players who entered this market
several years ago. This trend is most pronounced in the US, with the
rebound of commercial bank lending. Several high-profile transactions
have highlighted the perception of value in the mezzanine segment
of the market. Also, several dozen funds have cropped up as debt
originators for commercial mortgage-backed security deals.
Meanwhile, in Europe, a significant amount of refinancing is still
on the horizon. Commercial banks are unlikely to assume the entire
burden, which will continue to create opportunities for alternative
lenders.
The remainder of this section will delve into a number of global
markets, exploring where investors are hunting opportunities and
where funds are finding their niche. In all, for private equity funds,
there is no shortage of deal opportunities that will meet or exceed
their return targets, regardless of their geographic focus. But the
tremendous global interest in real estate means that almost none
of these opportunities are available for core assets in gateway
cities. Finding them means continuing to identify new holes in the
market to fill or accepting a greater appetite for risk. 2008 should
continue to serve as a reminder, however, that the market can only
be pushed so far.
Cross-border capital flow accelerating
Source: Real Capital Analytics
* Last 12 months, ending Q3 2014, excluding Chinese land sales
Destination
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| Global market outlook 2015
How capital inflows from foreign investors could result in a
burst of commercial property prices.
Bubble check: when will the
balloon burst?
1980s
Japanese investment in major
US cities
2015
Asian and European investment in
major US markets
Contracting business
cycle, declining gross
domestic product
Supply exceeding
absorption
Foreign capital inflows
distorting transaction
volumes and price
Development activity
well advanced
Market adequately
supplied with debt and
equity sources; property
leverage increasing
Inflation rises out
of control; assets
currently priced to
perfection. Reprice!
Over 25 years ago, EY tracked Japanese investment in US real estate
and marked the peak of Japan’s capital flows during 1988, when
investment dollars into trophy US assets reached US$17 billion.2
Although the development of REITS and the commercial mortgage-
backed securities (CMBS) market for investing in real estate has had
a profound impact on institutionalizing our industry, the universal
fact is that imbalances in capital flows into real estate have the same
effects and risks for creating an asset bubble now as they did then.
The disturbing truth is that the US and a handful of other markets
have a very scarce commodity of institutional-grade assets protected
by ownership rights and a rule of law that ensure institutional
investors a safe means of entry and exit. This is compounded by the
fact that many central governments around the world are seeking
diversification of trade surpluses and reserves. This is why it is not
surprising that foreign investment in 2014 topped US$39 billion,
a 14.7% increase from the inflation-adjusted 1988 peak of
US$17 billion.3
So when will the bubble burst? Asset bubbles, much like history, have
similar facts and circumstances, but rhyme more so than repeat.
Today, the size of the market is significantly larger and has a far more
diverse offering of debt to equity products.
Source: EY
Bubble check: 1980 vs. 2015
2. “Real estate: US slows,” Kenneth Leventhal & Co., 1990.
3. Real Capital Analytics, December 2014.
15
Trends in real estate private equity |
Real estate ranks high on European institutional investors’
investment priorities because of low returns in the bond
markets. Many institutional investors are looking to increase
their real estate allocations.
German institutional investors invested most heavily in
their domestic markets in 2014, rather than searching for
opportunities elsewhere. Their asset class of choice has been
retail, which is surprising for such a low-risk group. Eighty
percent of those polled said they had been chasing retail
investments, in spite of several high-profile bankruptcies among
large German retailers in the last couple of years. But unlike
foreign investors that come into European markets looking
for value-added retail with potentially high yields, German
institutional investors have focused on core opportunities:
modern shopping centers and high street retail, rather than
power centers or shopping centers in need of redevelopment.
In other asset classes, more than half also looked into the office
and residential sectors, while just below half are focusing on
industrial and logistics options.
For those that have explored real estate investments outside
of Germany, 2014 marked a significant shift, with only a third
investing in North America compared with more than half in
2013; rather, they have stuck closer to home, concentrating on
core European markets: the UK, France and Scandinavia.
Meanwhile, Germany is also starting to see more interest from
a new crop of foreign investors, particularly from Asian funds,
which are beginning to expand their European real estate scope
beyond the UK. Unsurprisingly, they are almost exclusively
in search of core opportunities. But with these becoming
increasingly difficult to find, a few have begun to make small
steps farther along the risk curve by considering core-plus deals
or ones that have a small value-added component, such as
vacancy improvements.
This means that for opportunistic private equity players,
returns are becoming narrower and narrower in Europe’s
northern markets. As a result, they are migrating south, to
Spain and Italy, where price discovery is underway through
increasing transaction activity. Those who continue to look for
opportunistic plays in Northern Europe are getting involved in
larger, more complicated transactions, such as ground-up new
development or complete redevelopment.
2014 has been a challenging year for Brazil, in spite of the
excitement of the World Cup. GDP growth has been sluggish,
with year-end results expected to fall in line with last year’s:
a glum 1%. Business was actually negatively impacted by
the football tournament, and the anticipation of October’s
presidential elections and a tense campaign cycle contributed to
uncertainty in Brazilian markets.
With these events and predictions in mind, enthusiastic
investors who joined the Brazilian real estate market several
years ago are now pulling back.
Furthermore, the downward trend in Brazil’s economic
performance has not boded well for the country’s existing
real estate stock. In São Paulo, the office market is highly
oversupplied. This is because of the number of new buildings
planned and started three years ago, when GDP growth
projections were more positive. Now, it could take up to two
years or more to absorb the city’s current supply.
Most of Brazil’s other office markets are facing some degree
of oversupply as well, though none to the extent of São Paolo.
Rio de Janiero is the one notable exception. Wedged between
mountains and the sea, the city’s geographic constraints
mean there is limited space for new development. In fact, the
redevelopment of its old port, Porto Maravilha, is one of the
country’s few new construction projects attracting investors,
including real estate private equity funds.
Two sectors where there appears to be near- to long-term
investment opportunity in Brazil, however, are logistics and
retail. The logistics market is currently in growth mode with
a spate of redevelopment projects converting single-owner
warehouses into modern, professional-grade properties.
Until now, most warehouse sites had been built by individuals
for small business use. There is a significant lack of larger-
scale industrial real estate infrastructure to cater to Brazil’s
transport and logistics industries. However, with the first
wave of conversions completed several years ago, domestic
real estate investors have been flocking to development and
redevelopment projects in this sector.
Meanwhile, growth in retail real estate has slowed substantially,
even though it is largely believed to be underbuilt. This is
especially true for shopping malls, which are attractive to
consumers for their security. Yet for a large emerging market,
Brazil has a small shopping mall footprint.
European market spotlight:
Germans love retail
Latin American market
spotlight: uncertainty wave
hits Brazil
Fund activity in the Asia-Pacific region has been heating up
around Australia. Historically an institutionally owned market,
Australia is beginning to open up to new sources of capital
with a need for recapitalizations, redevelopment and new
construction in its aging real estate stock. A key source of the
new money coming into Australian cities is Asian funds, which
see Australia as a core market. These funds are demonstrating
a willingness to explore higher risk opportunities there because
of Australia’s overall stability relative to other markets in
the region.
In general, however, Asian investors are looking to invest closer
to home more than they have in the past. Chinese funds, for
example, continue to allocate a significant amount of real estate
capital into the US and Europe but are increasingly exploring
opportunities within Asia as well. This marks a strategic shift,
suggesting that they are more convinced of their own regional
markets’ viability. However, in spite of the extent of opportunity
within China, Chinese funds are still slow to reinvest capital
domestically.
Across the region, real estate investment activity continues
to be stable, though less frenzied than in recent years. The
threat of interest rate increases in the US and moderating
growth in China have been a big contributor to the slowed pace.
Thailand’s market has shown resilience, in spite of political
turmoil. Indonesia has been hit because of last year’s currency
devaluation and this year’s elections.
Meanwhile, Malaysia and Singapore are both facing headwinds
in their residential markets, owing to strict equity requirements
for investment properties. Additionally, in Malaysia, there is
concern about oversupplied apartment stock as a result of
Chinese development. This is particularly true for the region
closest to Singapore, where residential prices have fallen as
much as 15%. In Singapore, investors’ perception is that the
residential market is overpriced and that cap rates are too low
to enter the market.
The REIT market in Singapore remains healthy, however, with
a number of new entities looking to be listed there, thanks to
market transparency and investors’ familiarity with Singapore’s
capital markets regime. Another market segment that is
expected to see heightened activity is Singapore’s office market.
Several high-profile deals are expected to hit the market, and
most of the buyer interest is expected to come from other
Asian investors.
Asia-Pacific market
spotlight: Asian investors
expand closer to home
16
| Global market outlook 2015
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Trends in real estate private equity |
Development finance in India
After years of standstill in new development, India’s real estate sector
is beginning to see a reawakening, particularly in housing. In the past
two years, several big name investors have reemerged on India’s
development scene.
Since the financial crisis, India’s heavy housing needs have been
largely unattended by major international real estate players. Much of
the capital invested in the previous cycle was pure equity that carried
a lot of risk. Burned by cost and timeline overruns, stalled projects
and unmet return targets, many investors have stayed away in spite
of market recovery. Policy paralysis under the previous government
played a key role in this.
Now, macroeconomic conditions have made it impossible for a
number of large international investors to ignore India’s development
opportunity any longer. A few are stepping back into the market,
albeit with new, less risky ways of investing. This year, several large
development projects have been financed in Bengaluru, Pune
and suburban Mumbai with a host of new mechanisms, including
structured debt, structured equity and mezzanine debt. Deals
involving high-cost, structured finance have been most active, given
the number of stalled projects from the last cycle that are looking for
financing to restart.
What’s more, investors from several global pension and sovereign
wealth funds are using these structures as platforms for investing
directly with local developers and financiers, rather than involving
fund managers. Some of them are acquiring assets aggressively and
have an eye for eventually monetizing them through a REIT listing,
making use of India’s new REIT regime, passed in August.
The election of Narendra Modi to office this year has also boosted
investor confidence in India’s market, and more business-friendly
policies like the REIT legislation are expected to follow. With that,
more foreign real estate investments are likely to follow.
Fundraising in Israel
US real estate investors in need of fresh funds have been turning to
Israel’s bond markets to raise capital. The handful of companies that
have taken this approach so far are finding that they can fundraise
through bond issuances on the Tel Aviv Stock Exchange (TASE) with
more favorable terms than they can in the US. Another two to three
of these deals are currently in the works.
This strategy is being tested primarily by midsize funds that otherwise
face a difficult fundraising environment in their home jurisdictions.
This is not an enormous trend at this stage, but with favorable
interest rates and low-cost capital available in Israel, the trend is
expected to continue.
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| Global market outlook 2015
Now: European Asset
Quality Reviews;
transactions to follow
The release of the European
Central Bank’s (ECB) Asset Quality
Review (AQR) results marked the
latest step in the ECB’s process
in attempting to set the region
on a surer footing for growth.
The exercise, which assessed
the balance sheet strength and
economic shock resistance for
nearly 125 banks across the EU
may not seem ideally timed, given
the current economic outlook for
the Eurozone. However, it was
arguably the quickest and most
effective way to level the playing
field for banks under the ECB’s
direct supervision.
5
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Trends in real estate private equity |
become clearer. Banks and regulators will have a much deeper level
of knowledge to draw from in paving the way forward, given the scale
and granularity of the AQR exercise. These insights will both finesse
the banks’ recovery and resolution plans and facilitate the creation of
a single resolution mechanism.
As for the real estate market, the banks’ process for navigating the
way forward will likely have a significant impact on new opportunities
for the foreseeable future. There will undoubtedly be a sizeable
volume of sales coming to the market in the near term, including both
loan books and unresolved foreclosed assets. Private equity funds will
certainly have a role to play in resolving key pools of capital.
Potential consequences of AQR
Although the impact of AQR results on the supply of loans to
transaction markets is unclear, there are a number of potential
consequences. Furthermore, resetting the dial for the region’s main
banks is essential to a sustainable Eurozone economic recovery and
to instilling market confidence in the region going forward. The ECB
has taken important measures this year to try to kick-start funding
for the real economy. These include the Asset-Backed Securities
(ABS) and the Targeted Long-Term Refinancing Operations (TLTRO)
programs, with both measures relying on a strong banking sector for
transmission into the wider economy.
Once the dust settles on the AQR results, the way forward for both
the banks and the businesses that rely on them for funding should
Capital requirements timeline
Source: EY
1 Jan 2015
1 Jan 2016
1 Jan 2017
1 Jan 2018
1 Jan 2019
Capital
requirements
Phased in
Full compliance
Capital Requirements
Directive (CRD) IV leverage
ratio
Public disclosures begin
Binding requirement
Net stable funding ratio
Observation period
Introduction of minimum requirement
Liquidity coverage ratio
60% compliance
required
Phase to full compliance
Full compliance required
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| Global market outlook 2015
BEPS and other tax updates
Several years of intensified
efforts by global tax authorities
to combat tax evasion and
avoidance have finally resulted in
a collective effort led by the OECD
with the support of the finance
ministers of the G20, focusing
on BEPS. Last year, the OECD
released its first set of measures
to help ensure that businesses
are adhering to tax regimes
where they are based. The aim is
to finalize these action plans by
September 2015.
6
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Trends in real estate private equity |
Substance
Regulated vs. unregulated collective
investment vehicles
Reporting and compliance
Hybrids
No need for immediate action
Direct relevance to the
RE fund industry
Most real estate funds will pool international investors in order to invest
in a particular region (e.g., US and Asian investors will invest in
European real estate). Therefore, they will usually route this investment
through one jurisdiction, such as the Netherlands or Luxembourg, both
for reasons of administrative simplicity and to minimize tax leakage
through access to the treaty network of that country. The BEPS
program proposes restricting access by a company to treaties only if
one of the three tests below are satisfied.
1. Firstly, that it is a qualifying entity; broadly, one that is publicly listed
in that country or controlled by a listed company in that country
2. Failing this, that it has sufficient business activities in that country;
the guidance is clear that being a holding company passively
managing investments is not sufficient
3. Finally, that the company was not put in place with a main motive of
claiming treaty benefits
In light of industry feedback from an earlier draft, the OECD has
proposed that countries could consider adding collective
investment vehicles (CIVs) to the list of qualifying entities able to
automatically claim treaty benefits (albeit with potential
restrictions as to whether full relief is available). A CIV is not
clearly defined but is generally a diversely held investment
vehicle subject to investor-level regulation — such as a UK
open-ended investment company (OEIC) or a Luxembourg
société d'investissement à capital variable (SICAV). Although the
OECD promises to consult further on similar protection for
alternative funds such as private equity real estate, no further
details are available as yet.
It is clear, therefore, that the trend in recent years for greater
substance requirements in any fund vehicles will only increase,
and fund managers should bear this in mind while making future
expansion plans.
Clearly, if implemented as proposed, BEPS may have significant
implications to the complexity, tax efficiency and running costs of a
typical real estate fund. However, implementing this process will require
global cooperation between governments, and given that many of these
carry significant political implications, although there is a clear will of the
OECD as an organization to implement this, whether full cooperation
from governments can be secured in a timely fashion is impossible to be
assessed at this time. However, action to ensure appropriate substance
and beneficial ownership in relevant jurisdictions is of the highest
importance. Fund managers should consider the use of domestic
exemptions from withholding taxes (so as not to rely on treaties) and/or
local tax-efficient vehicles (e.g., REITs, Organisme de Placement Collectif
en Immobilier (OPCIs) or and sociedades cotizadas en el mercado de
inversión inmobiliario (SOCIMIs)) to ensure their structures meet the
objectives and goals of their investors.
“Hybrids” is shorthand for financial instruments or entities with
differing treatments in two jurisdictions (e.g., equity in country A and
debt in country B or capital/income or opaque/transparent). The OECD
is proposing a mixture of treaty and domestic law changes to remove
the tax advantages potentially achievable by arbitrage between these
treatments. Of interest to real estate funds is that these rules would, if
implemented as proposed, lead to funds having to consider the tax
treatment of investors on funding instruments and potentially disallow
expense at fund level.
Although country-by-country reporting is principally aimed at
large multinationals, the same requirements are likely to apply
to multinational fund structures, which will give much more
visibility over structures to tax authorities than what has
historically been the case.
BEPS program
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| Global market outlook 2015
The centerpiece of the BEPS action plan is, in the modern economy,
to prevent the diversion of profits from where the commercial activity
takes place to low-tax jurisdictions and also to give tax authorities
the information to help combat this. Associated with this is the rise
of the digital economy, where cross-border transactions present
jurisdictional issues such that the existing framework of international
tax is perceived as outdated. The key practical impact for the RE
fund space is that the concept of “commercial substance,” that is,
“brass plate” companies in low-tax jurisdictions, will no longer be
effective, and that an appropriate level of management is required in
a jurisdiction to support the assets or activities it owns or carries
out. Released parts of the action plan address these issues through
several channels relevant to real estate funds. One is through
potential transfer pricing reporting transparency. Under the plan,
reporting measures would tighten for pan-European funds with
holding companies in multiple jurisdictions; they will have to report
in “one master file” details of their global operations, structures,
etc., which will be shared automatically with tax authorities where
they operate. Funds can now expect to face a heavier burden directly
in collating and preparing this information and also in proving they
have substantial staff, operations and decision-making capacity at the
holding company level to justify having that location as their tax base.
Another area being addressed is accountability for all hybrid
instruments and entities (i.e., where there is a mismatch between
treatments in jurisdictions). The proposal is that the taxpayer
(defined broadly) would not be able to achieve non-taxability of
income or a deduction in two countries for the same expense.
Macroeconomic difficulties resulting in depleted tax reserves has also
been a key issue in many countries, which leads them to renegotiate
their treaties so they have an opportunity to further raise tax on
transactions involving their jurisdictions. Poland was among the first
to negotiate this kind of agreement with Luxembourg, which resulted
in Poland reclaiming the right to tax any Polish real estate entity sold
by a Luxembourg-based fund that Luxembourg chooses not to tax.
The Luxembourg-Germany and Netherlands-Germany treaties now
function similarly and France has recently renegotiated its treaty
with Luxembourg along these lines (expected to come into force from
1 January 2015 or 2016). Meanwhile, Spain is considering similar
agreements with the Netherlands.
What is driving these measures is pressure within a number of
European countries to improve revenue streams. The challenge,
of course, in designing these policies is how to successfully drive
revenue without stifling investment. A number of European countries
are concerned about adopting overly strict or punitive measures and
are carefully considering how to implement effective tax regimes that
will still draw investors.
As for the BEPS action plan, specifically, implementation could pose
a challenge for some since enforcement will be both the responsibility
of in-country agencies and written into bilateral treaties. Currently,
an investigation is under way, considering the option of a multilateral
convention that would sit above country-to-country agreements;
the OECD has obtained legal advice that such an approach is legally
feasible, but the political difficulties in organizing such a convention
and its potential scope should not be underestimated.
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Trends in real estate private equity |
Trends in fund reporting
AIFMD and EMIR
The Alternative Investment
Fund Managers Directive, more
commonly known as the AIFMD,
finally came into full effect on
22 July 2014. By this date, fund
managers within the scope of the
directive were required to have
submitted their applications for
authorization to manage and/or
market alternative investment
funds in the European Union.
Also coming into effect is the
European Market Infrastructure
Regulation (EMIR), which its
designers hope will provide
more stability and increased
transparency in the over-the-
counter derivatives market.
The first requirement, the EMIR
portfolio compression obligation,
involving the reporting of
derivatives was effective in 2014.
Further, certain fund managers
may be classified as Financial
Counterparties (FCs) and they will
have to comply with the full range
of EMIR requirements when they
finally come into effect, including
the upcoming central clearing
and cash collateral posting
obligations, which many believe
will be burdensome.
7
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| Global market outlook 2015
The European Association for Investors in Non-Listed Real Estate
Vehicles (INREV) released a survey on 9 December 2014, exploring
the impact of regulatory compliance, such as the above, on the non-
listed real estate funds industry. Fund managers reported that AIFMD
depositary and operational requirements were the most challenging —
both before and after application for authorization — and that the
costs of complying with AIFMD were considered significant. INREV
reported that “Many fund managers say they are still concerned
with reporting to local regulators. At the heart of this concern is the
AIFMD’s requirement that the reports be validated, formatted and
posted 30 days after the end of the reviewed period (or 45 days for
fund of funds) – an onus for an industry that, heretofore, has not
implemented methods for handling such reporting granularity or
frequency, and a very narrow window for managers with multiple
funds. For funds that report quarterly, the challenge is particularly
acute.”
In contrast, the survey revealed that EMIR’s current reporting
obligations were delegated by most managers and that the associated
cost was not considered significant, despite the challenge of meeting
the first reporting deadlines for many respondents.
Transparency
Large institutional investors such as pension funds, family offices and
insurance companies continue to demand more transparency over
investment activity and products on behalf of their stakeholders.
For example, stakeholders may apply pressure on fund managers to
comply with the Global Investment Performance Standards (GIPS).
GIPS are a voluntary set of standards — based on what the authors
see as fundamental principles of fair representation and full disclosure
of performance results — that were created to provide an ethical
framework for the calculation and presentation of the investment
performance history of an investment management firm.
It’s also important to note that the AIFMD requires that all information
provided in the annual report be presented in a manner that provides
relevant, reliable, comparable and clear information that investors
may need in relation to particular alternative investment fund (AIF)
structures. Perhaps particularly challenging is the information to be
provided about manager remuneration, fee structures, risk profile
and management and investment strategies.
Alternative performance and non-GAAP financial
measures
In 2014, the European Securities and Markets Authority (ESMA), the
European public financial reporting regulator, launched a consultation
on “Guidelines on Alternative Performance Measures” (APM). ESMA
sets out that “The aim of the guidelines is to improve the transparency
and comparability of financial information, reduce information
asymmetry among the users of financial statements, coherent use and
presentation of alternative performance measures (APMs) and finally
to contribute to restoring confidence in the accuracy and usefulness of
financial information and improve investor protection.” Although the
guidelines apply mainly to issuers of public securities, these guidelines
may also become common practice in the European fund industry.
The final guidelines are expected soon.
The International Organization of Securities Commissions (IOSCO)
continued the theme with its 2014 consultation on its proposed
Statement on Non-GAAP Financial Measures (NGFMs), which partially
overlaps the APM. However, where the APM also comprises measures
designed to illustrate the physical performance of the activity of an
issuer’s business, IOSCO’s NGFMs only relate to financial numerical
measurement of an issuer’s current, historical or future earnings,
financial performance, financial position or cash flow that is not
determined by GAAP.
SEC developments
In June 2014, the US Securities and Exchange Commission’s (SEC)
Division of Investment Management issued a Guidance Update for
Private Funds and the Application of the Custody Rule to Special
Purpose Vehicles. Under one of several scenarios in the guidance,
the SEC clarified that a special purpose vehicle, such as a vehicle
created for tax purposes with third-party investors, may need to be
considered as a separate client for purposes of the Custody Rule.
In some circumstances, the SEC examination staff have applied this
guidance and issued deficiency letters indicating that the private
REITs inserted in private fund structure for tax purposes should be
considered a separate client and subject to the provisions of the
Custody Rule, thereby requiring a separate financial audit. Individual
circumstances are different, and legal counsel should be consulted
when performing an evaluation of the entities that meet the definition
of separate clients under this updated guidance.
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Trends in real estate private equity |
Investment entity financial reporting
A new international model
Perhaps the most significant development in reporting this year was
the release of the new International Financial Reporting Standards
(IFRS) ‘Investment Entity’ exception. This new model brings IFRS
guidelines closer in line with US GAAP, potentially enabling real estate
funds in multiple jurisdictions to use similar accounting practices – a
step in the right direction to standardize data points and to improve
fund comparability globally.
This exception means that for entities in scope, subsidiaries would
not be consolidated, but rather the investment therein would be
measured at fair value. This exception applies if:
• An entity obtains funds from one or more investors for the purpose
of providing investors with professional investment management
services.
• An entity’s main purpose is to invest funds solely for capital
appreciation, investment income or a combination of capital
appreciation and investment income.
• An entity measures/evaluates performance of substantially all
investments on a fair value basis.
New guidance for existing US GAAP model
At the same time, for US GAAP reporters, under new guidance for
investment companies, an entity that is regulated by the SEC under
the Investment Company Act of 1940 (the Act) automatically qualifies
as an investment company. Entities that are not regulated under
the Act must have certain fundamental characteristics and consider
other typical characteristics to determine whether they qualify as
investment companies. An entity should consider its purpose and
design when making the assessment.
An investment company must have the following fundamental
characteristics:
• The entity obtains funds from one or more investors and provides
the investor(s) with investment management services.
• The entity commits to its investor(s) that its business purpose and
only substantive activities are investing the funds solely for returns
from capital appreciation, investment income or both.
• The entity or its affiliates do not obtain or have the objective of
obtaining returns or benefits from an investee or its affiliates that
are not normally attributable to ownership interests or that are
other than capital appreciation or investment income.
Typically, an investment company also has the following
characteristics:
• It has more than one investment.
• It has more than one investor.
• It has investors that are not related parties of the parent (if there is
a parent) or the investment manager.
• It has ownership interests in the form of equity or partnership
interests.
• It manages substantially all of its investments on a fair value basis.
An entity that does not have one or more of the typical characteristics
could conclude that it is an investment company, but it would
have to apply judgment and determine, considering all facts and
circumstances, that its activities continue to be consistent with those
of an investment company.
These US GAAP guideline updates are otherwise unlikely to
significantly impact real estate funds already qualified under the
structure. REITs continue to be scoped out of this guidance, although
we understand that diversity in practice remains on the application for
private REITs set up for tax purposes, and it will likely be an issue that
continues to be hotly debated in the near term.
As discussed above, this US GAAP assessment is similar to that under
IFRS, except under IFRS an investment company must measure and
evaluate the performance of substantially all of its investments on
a fair value basis and must have an exit strategy for investments
without stated maturity dates. Crucially, though, for IFRS real estate
reporters, the Investment Entity exception contains specific guidance
for real estate. This acknowledges that most real estate investments
require active management — such as leasing, cap-ex, redevelopment
and maintenance — and these are activities may preclude the entity
from meeting the criteria as an Investment Entity.
Therefore, a real estate fund that actively manages its assets and
does not have a defined exit strategy may not meet the criteria to
be an Investment Entity under IFRS. We do not currently observe
many real estate funds in Europe seeking to adopt this new reporting
model, but this may change over time.
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| Global market outlook 2015
One interesting result from the potential alignment of the US GAAP
and IFRS reporting models could be that, as this reporting model
is operationally easier to implement, a number of funds could
explore how to outsource their reporting functions. As with most
outsourcing discussions in the fund space, this is primarily a cost-
driven consideration, although administrators may be better equipped
to serve entities utilizing this reporting model, making it a more
feasible option. This particular change seems to be motivating funds
to explore bigger outsourcing strategies.
Other new international financial reporting
standards
For funds not reporting under the Investment Entity exception,
other recent changes to IFRS may also have an impact. IFRS 10,
11, 12 and 13 came into effect on 1 January 2013 (albeit IFRS 10,
11 and 12 were not mandatory until 2014 for entities reporting
under European Union-approved IFRS). We cover certain aspects of
these below.
IFRS 11 applies to joint arrangements and sets out that partners to
the venture should account for their direct rights to its assets in the
arrangements and their joint liability for its obligations (similar to
proportionate consolidation) only if those rights exist. For transparent
entities like partnerships, that may be the case, but many other
structures do not meet these criteria and for them equity accounting
is mandatory. IFRS 11 has therefore tended to lead to equity
accounting instead of proportionate consolidation as seen under the
previous accounting standard.
IFRS 13 is concerned with fair value measurement and disclosures
thereto. For the real estate industry especially the amount of
real estate valuation disclosures about significant assumptions,
unobservable inputs and the level of aggregation (segmentation)
of such disclosures is a significant issue. In the first reporting year
after IFRS 13 came into effect, we noted considerable diversity in the
level of such disclosures and we expect that there will be regulatory
interest and some harmonization in this respect in future periods.
Separately, for fund managers themselves, IFRS 10 may require some
to consolidate the assets and liabilities of the funds it manages into
its own financial statements. Consolidation is required if the fund
manager is considered to control the fund, which is the case if the
fund manager has:
• Power over the fund
• Exposure, or rights, to variable returns from its involvement with
the fund
• Ability to use its power over the fund to affect the amount of its
returns
IFRS 10 provides an example where a fund manager has to
consolidate the fund it manages if it (1) has a 20% interest in the
fund, (2) can only be removed as manager for cause, (3) has broad
decision rights and (4) a variable remuneration of between 1% of
net asset value and 20% of profits if certain hurdles are met. Clearly
interpreting whether a fund manager controls a fund will require
considerable judgment. In this respect, the Investment Entity
exception may provide a safe heaven.
Integrated reporting
An integrated report is a concise communication about how an
organization’s strategy, governance, risk management, performance
and prospects lead to the creation of value over the short, medium
and long terms. In our experience, investors like the introduction of
integrated reporting and, despite identifying concerns and obstacles,
many fund managers look forward to its development and progress,
viewing integrated reporting as an improvement in disclosures for
investment decision-making.
As a consequence, integrated reporting is commonly seen as
enhancing significantly the reputation and competitiveness of a fund
manager. The tendency to move to integrated reporting will soon be
the norm.
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Trends in real estate private equity |
Outlook
In this year’s Global market outlook,
we have focused substantially on
the amount of global capital chasing
real estate investment opportunities.
Looking forward to