Hong Kong, 15 February 2011
In the wake of the financial crisis, there has been some recent discussion of the role of real estate financial markets in contributing to the crisis, and the lessons going forward. For example, ULI chairman Jeremy Newsum recently made some pointed criticisms of closed-end funds.
See the following article in which Jeremy Newsum shares his thoughts on the role of closed-end funds: There Were Many Keys to This Bomb and We Held One.
Following are thoughts from Simon Treacy, Group CEO of MPGA*, and a ULI member, on the topic of closed-end funds and their role in providing investors access to otherwise inaccessible markets, community building, financial engineering, and in the cycles of real estate markets.
How do you see the role of closed-end funds?
Learning lessons and trying to avoid them in the future is the right, and at times humbling, topic for the real estate industry to reflect upon. I recognize that some sponsors of close-end funds did become a “puppet of finance” and suffered the consequence, but we must recognize that in a market as diverse and capital intensive as real estate, attracting capital through creating an “investment opportunity” is as important as attracting it for a ”building for occupation.”
How do you see the role of closed-end funds specifically?
Well first, let’s remember there are many vehicles available for real estate investment, ranging from publicly quoted enterprises and REITs, through open-ended vehicles, private companies, closed-end funds and direct ownership. Each of these has a place and a context in the larger spectrum of real estate investment.
Real estate has internationalized significantly over the past 15 – 20 years. Closed-end funds became commonplace in the early 1990’s as sponsors sought to raise capital to recapitalize an industry that had suffered a collapse as a direct result of its own activities. Since then they have also been utilized to allow investment in new international real estate markets such as Japan, South Korea, China, Brazil, Russia, India and Central and Eastern Europe.
As a result they (the funds) have opened them (new markets) up with the introduction of more organized foreign capital, sophisticated management and better designed and developed buildings.
Closed-end funds provide investors access to otherwise inaccessible markets. They are typically operated by local real estate operators and developers who are seeking to exploit a market opportunity that cannot be financed through traditional sources. For international capital, they provide a vehicle that gives access to a particular market without requiring the resources demanded by other investment vehicles in terms of property level underwriting and local presence.
What about the argument for the importance of patient money, the “slow buck,” to maintain stability?
I think that this comment might be more applicable to the equities market than real estate. In the modern world a period of 7 to 10 years, the typical life of a closed-end fund, can hardly be considered “quick” when compared to the equities market.
More importantly, most buildings have a life expectancy of around 25 to 30 years before they need redevelopment or major renovation. To hold an asset for a third or more of its expected life can hardly be considered “short termism.”
I believe that the real estate industry benefits from shorter term capital seeking to access the market at a point where there is limited demand and producing an asset that the balance of the market is seeking. For example, at the present time, in most markets the yield spread between primary and secondary properties is at an all-time high, as capital becomes risk averse.
The result is that we see opportunities to invest in properties that can be improved and then sold to the wider market thereby capturing a large part of the yield spread and providing attractive returns. This, I believe, is a valuable role that the closed-end fund can play in the current environment that should not be dismissed in the name of the “slow buck.”
Do you agree about the need to focus more on operations and “community-building,” and less on finance and “financial engineering”?
I don’t really see these factors being in opposition, but we must recognize that the real estate market is driven by three cycles: the capital market cycle, the real estate fundamentals cycle (supply and demand) and the property cycle (building age). At different points in time these cycles have a different level of impact on real estate but as they interact they make real estate a highly cyclical asset class.
The capital markets will always be part of the real estate world. However, so will real estate fundamentals. It is striking a balance between them that is the challenge and the lack of balance and excessive reliance on finance that got us in trouble as Jeremy points out.
I do not believe that operations and “community building” are mutually exclusive to making a profit facilitated by finance or “financial engineering.” In two of its closed-end funds MGPA is currently developing major “community-building” projects. In Singapore we are developing 2.5 million sq ft (232,257.6 m²) Asia Square office development, The Human Building, and in Kuala Lumpur the 2.5 million sq ft (232,257.6 m²) mixed-use project, The Intermark.
Coming out of the post-crash period, what do you see as the major lessons, major remaining dangers, and major opportunities?
People in real estate tend too often to forget that real estate has been and will always be a cyclical asset class. It continues to amaze me that people get surprised when real estate markets turn down. Risk management is hence very important to manage financial exposures and expectations of all parties. Prices don’t go up for ever and it is unusual that you would not go through a down turn even during the period of undertaking a major development. Over time, real estate will outperform bonds and cash and provides arguably a better protection against inflation than stocks.
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*MGPA is a global private equity real estate investment company with a $10 billion portfolio in Asia and Europe. We talked to Simon Treacy, Group CEO and ULI member, at his office in Singapore.
