Delivering liquidity in real estate

In recent years, institutional investors have been investing an increasing amount of their capital in open-end funds that invest in private real estate. Investors like the flexibility of being able to come in and out of their investments on their own schedule, as opposed to waiting until the end of the term of a closed-end fund, or seeking to sell their fund interests into the thinly traded secondaries market. While publicly traded real estate investment trusts (REITs) offer daily liquidity, the public markets are much more volatile than private real estate.

How are open-end funds different from traditional closed-end private equity funds? Open-end funds typically have an indefinite life. Investments are usually valued on a quarterly basis, based on appraisals. Investors are able to make new investments and redeem existing investments quarterly, based on the net asset value (NAV) of the fund. Distributions are also paid with the same frequency, although many investors elect to reinvest these distributions.

Unlike a closed-end fund, where management fees are based on capital commitments or capital contributions, management fees in an open-end fund are based on NAV.  If any incentive compensation is paid to the manager of an open-end fund, it is typically based on both cash proceeds, as well as unrealized appreciation in NAV.

Hedge funds of course are also open-end in nature.  However, the public securities in which hedge funds invest are much more liquid than private real estate. While open-end real estate funds may offer quarterly redemptions, this is subject to there being cash available to satisfy redemption requests. Funds are usually not required to sell assets to make redemptions. After the market downturn in 2008-2009, investors sought to rebalance their real estate allocations with their decreased public equity investments by submitting redemption requests for their open-end fund investments. This resulted in long redemption queues and was exacerbated by further decreases in private real estate valuations while investors were waiting for their redemptions.

Many open-end real estate funds invest in core real estate. Core assets consist of high quality, owned properties in major markets leased to high credit tenants, with minimal vacancies and low leverage. Core real estate derives more of its returns from current, rental income, rather than appreciation, and is more easily valued. Some open-end funds invest in core-plus, value-add and debt strategies. However, these asset classes may not be as easily valued on a quarterly basis and are not used frequently for open-end funds.

Open-end real estate funds are often structured as REITs, or invest through entities treated as REITs, for US tax purposes. Many foreign investors can avoid some of the tax issues presented by the Foreign Investment in Real Property Tax Act (FIRPTA) by investing in “domestically controlled” REITs, majority owned by US investors. This and the low risk, current income qualities of core assets have made core open-end funds very attractive to foreign investors. In fact, many legacy open-end funds, which were originally structured as insurance company separate accounts or bank collective trusts, have recently restructured themselves as REIT-based funds to permit the investment of foreign capital. 

Another long-term goal in private real estate investing is to attract capital from individuals. Most private employers have done away with their corporate pension plans and now only offer 401(k) or other defined contribution plans. Many feel that the governmental pension funds, which are defined benefit plans, will eventually move in the same direction. The defined contribution market typically requires daily valuation and liquidity for its products. While open-end real estate funds usually do not offer valuation and liquidity on a daily basis, they can be paired with public REIT securities to create effective products for defined contribution investors.

Many of the funds on the NCREIF Fund Index – Open End Diversified Core Equity (ODCE) now have billions of dollars of assets. It can be difficult to start a new open-end fund without a sizeable seed portfolio. As mentioned above, many foreign investors do not want to invest in a fund unless it is domestically controlled by US investors. New open-end fund managers often must provide financial incentives to their initial investors to provide seed assets and/or keep their money invested during the initial life of the fund.

Today, many core open-end funds have long lines of investors waiting to put in more capital. Larger investors may seek out separate accounts with real estate managers, where they can pay lower fees and have more discretion. Core assets are already becoming more costly, thereby generating lower returns, due to the attractiveness of low risk, income producing assets in a low interest rate environment. The pressure on fund managers to deploy waiting capital could lead them to acquire more expensive assets than they otherwise would, and drive up prices even further. Lower returns have led investors to put more of their capital into closed-end funds with value-add and opportunistic strategies. Nevertheless, core open-end real estate funds remain an essential component of most institutional investors’ portfolios.

Matt Posthuma is a Chicago-based partner in Mayer Brown’s private investment fund practice.