Over the last few years, the global economic environment has rapidly changed with profound implications for the businesses operating within it. The slow subsequent recovery has led to a fundamental rethink among many investors and asset managers, and previously accepted practices are now being re-examined and challenged. In addition, what were formerly best practices are now becoming required practices for successful ventures.
One of the key elements being scrutinized by investors as part of the performance improvement and monitoring process is the cost effectiveness of real estate fund products. This can be achieved only through a well structured and ongoing cost monitoring process.
When economic conditions were favorable and portfolios were growing, fund managers often overlooked the importance of their cost base, especially since many costs were borne by funds and not the fund managers themselves. Now that business activities in general are slower than before the financial crisis, there is an increasing demand from investors for benchmarking, transparency and monitoring. As the industry moves into the next economic cycle, real estate fund managers should take this opportunity to analyze and benchmark their current cost of doing business and, accordingly, design and establish an insightful and efficient approach to analyze their cost basis.
Real estate fund managers and administrators in the current economic environment are challenged with delivering more relevant and transparent reporting to investors in line with leading real estate fund practices, simultaneously demonstrating the cost effectiveness of their real estate fund products. An important element in striking the right balance can be achieved only through a more technical cost accounting and monitoring process. In order to remain competitive and address this issue, real estate fund managers need a fresh look at their strategies, business processes and outsourcing arrangements.
A cost monitoring mechanism will help fund managers in the following ways:
• Provide a means of communicating management’s plan throughout the structure that can serve as a benchmark for evaluating subsequent performance in an integrated manner;
• Assist in achieving a balance between security and cost of control (e.g. business process reengineering);
• Potential cost savings by reducing and/or rebalancing operational, infrastructure and management costs;
• Monitoring of cost effectiveness of operating platform, including service providers, in-sourcing/outsourcing, etc.;
• Indentify potential IT performance improvement areas, from strategic alignment to day-to-day operations;
• Provide a framework for responsibility accounting and its reporting to investors and other stakeholders (i.e. increased transparency and competitiveness).
Guidelines and tools
The development of industry guidelines by organizations such as the European Public Real Estate Association (EPRA) and the European Association for Investors in Non-listed Real Estate Vehicles (INREV) has helped the real estate fund sector move forward in this respect. One of the parameters recommended by these guidelines on cost monitoring is the calculation and reporting of backward- and forward-looking cost ratios, i.e. total expense ratio (TER) and real estate expense ratio (REER). These ratios describe the correlation between the cost bases and value of assets under management.
In accordance with INREV guidelines, the cost of running a fund should be classified under the following categories:
• Management fees
• Fund expenses
• Property specific costs
• Performance fees
• Other exempt costs
In accordance with these guidelines, TER expresses operating costs (management fees plus fund expenses) borne by the fund, while REER captures both the fund level expenses included in the TER and property-specific costs. These ratios should be calculated based on both weighted average gross asset value (GAV) and weighted average net asset value (NAV) over one year.
As per the recent poll carried out by Ernst & Young for real estate fund managers operating in Europe, the Middle East, India and Africa, 40 percent of the fund managers are not calculating TERs and REERs. Of the remaining 60 percent, only 20 percent are calculating these ratios for investor reporting as well as using these ratios as a cost monitoring tool. This shows that fund managers are either not conscious of the cost effectiveness of their products or do not perceive these ratios as an effective cost monitoring tool.
One of the challenges of using these ratios is that they are validly compared with the right industry peers. Also, this information should not only be used for investor reporting to comply with best practices, but also deeply analyzed internally for benchmarking and cost monitoring purposes.
In addition to these guidelines, other tools that are commonly used in establishing the cost monitoring mechanism are:
• Implementation of budgetary controls, including the process of setting budgets, financial calendars, variance analysis and periodical reporting, corrective actions, etc.;
• Setting key performance indicators (KPIs) for each process;
• Benchmarking the results as per the leading real estate funds practice.
In the case of real estate funds, in particular those with fully or partially outsourced operating platforms, operating effective budgetary controls can be challenging. They require coordination and efficient communication between various service providers – not easy when the fund has investments in many locations and different service providers with dissimilar systems. When establishing a budget, it is equally important to consider what the fixed, variable and semi-variable costs are. It is only after understanding cost dynamics that managers can take measures to establish realistic budgets and to fully take these relationships into account when designing new products and achieve specific set targets.
KPIs for a real estate fund should be set for each process. Most fund managers set KPIs only at the operational level of the fund, such as the number of days of tenants’ receivables, vacancy level, revenue per square meter for location and type of assets, etc. In order to make each process effective, KPIs should be set at all levels of the real estate fund structure, i.e. strategic, portfolio, financial accounting and reporting and compliance. For example, at the strategic level, one of the KPIs could be how many deals out of the total opportunities identified are successful and the number of days it takes to finalize the deal. By measuring this, fund managers can work out the lead time involved in the process and, by focusing on reducing the time it takes, can reduce the additional cost incurred.
Cost benchmarking is a process well established in other asset classes. It can be used as either a tool in itself or as an element of a business process reengineering project. It is the process of identifying, understanding and adapting best practices and processes from other organizations. It helps in developing realistic goals and encourages a striving for excellence, underpinning the drive for performance improvement.
Dimensions and cost implications
In order to analyze a real estate fund’s cost dynamics and to intelligently compare it with other similar funds in the industry, it is necessary to consider the dimensions in which they are operating.
Typically, there are four dimensions in which real estate funds operate:
• The geographic dimension describes the location of its assets;
• The strategic dimension describes its strategic objectives (i.e. core, value added or opportunistic);
• The sector dimension describes the types of assets in which it invests (i.e. residential, industrial, retail, infrastructure and multi-sector);
• The life cycle dimension describes the stage in its life cycle (i.e. investment, holding and divestment).
All four dimensions play a pivotal role in the cost structure of a real estate fund.
In addition to these dimensions, an important point to consider while analyzing the cost structure of a real estate fund is the design of its operating platform (i.e. in-sourced / outsourced / partially outsourced). Although design of the operating platform also depends on the resources available to the fund managers, and sometimes on the geographic coverage, it needs to be considered simultaneously while analyzing the cost structure.
The way forward
Business organizations are at a crossroads. Real estate fund managers need to realign their approach in order to make their real estate fund products cost effective. Implementing an intelligent and sustainable cost monitoring program will enhance performance in the longer term.
About the Authors:
Michael Hornsby is a partner and real estate practice leader at Ernst & Young, Luxembourg. He can be reached at email@example.com.
Zeeshan Ahmed is a senior manager at Ernst & Young, Luxembourg. He can be reached at firstname.lastname@example.org.
Farhan Ahmed is a manager at Ernst & Young, Luxembourg. He can be reached at email@example.com.
About the Firm: Ernst & Young is committed to support innovations and help provide insights to develop the real estate asset management sector. In support of this aim, we are extending an initiative to collect and analyze high-level fund cost data covering regulated real estate investment structures domiciled in Luxembourg. Luxembourg is a significant domicile for international real estate funds, including all styles, asset types and geographies. By analyzing the data using the above model, the results should help fund managers identify trends and better benchmark their cost structures with industry peers.