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E&Y: Real estate funds must “adapt to new regime”

Private equity real estate funds are being challenged by liquidity issues, not only from the lack of financing in the capital markets but also from rising costs related to other significant shifts in the industry, according to a new report from the accounting and advisory services firm.

Private equity real estate firms are facing a time of major upheaval in the industry, making it more difficult to raise and invest funds.  But while the lack of liquidity in the debt markets may present the biggest challenge, managers also must contend with other structural and cultural changes.

“Driven by regulatory requirements and heightened demands from investors, the changes are not merely cyclical adjustments to the market,” according to Ernst & Young’s latest Global Market Outlook: Trends in real estate private equity report.  “Rather, funds will have to adapt to a new regime.”

The changes will put significant cost pressures on many funds that already are affected by substantially lower asset valuations than three to five years ago. However, the costs are not limited to the expenses associated with complying with new regulations that directly affect real estate funds, such as the Dodd-Frank Act in the US and the Alternative Investment Fund Managers directive in Europe.

Indirect regulatory changes also will have an impact on fund costs. Basel III, for example, will require banks to hold more reserves against commercial real estate lending, which will in turn restrict the leverage available to funds.

Adding to the costs of regulatory compliance is pressure from investors for fund managers to lower management fees, which typically cover a firm’s operating and administrative costs. Managers have agreed to lower rates in recent years in order to retain and attract new business. However, this means that firms overall may have to survive on less capital.

Meanwhile, these rising costs are occurring against a backdrop of continued illiquidity in the capital markets. “The lack of available bank debt has stifled deal flow and limited the pace of recovery outside of primary markets in North America and Europe,” Mark Grinis, E&Y’s global real estate fund leader, wrote in the report. “Even the once booming emerging markets are feeling the impact of bank lending constraints,” largely because of uncertainty in the capital markets surrounding the Eurozone crisis.

Meanwhile, fundraising remains tough, with managers taking an average of six to seven months longer to reach a first close on a new capital raise than they did during the peak. However, in an effort to boost fundraising success, more managers have been pursuing niche investment opportunities, the report stated.

For example, in a survey of more than 300 private equity real estate firms, 18.8 percent of respondents expected to develop a single-family residential strategy, while an additional 18.7 percent said they may. Already, several major private equity real estate firms are raising dedicated rent-to-own funds for the single-family housing sector, with a total target of roughly $2 billion. Senior debt funds also have seen greater demand in markets such as China, where banks have been constrained by local regulations, and Europe, where banks also have pulled back on lending.

Despite an emerging environment for funds that “is not for the faint of heart,” managers overall remained fairly optimistic about their fundraising prospects. In the E&Y survey, 41.2 percent of respondents said they expected to raise more capital for their next fund than they did for their previous offering, while 30.2 percent expected to raise about the same and 28.6 percent anticipated raising less.