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FEATURE: Defining characteristics

“You can call something a horse, when it clearly is not a horse. But if no one really knows what kind of animal it is, then you cannot really be accused of misusing the word.”

This is how one London-based fund manager describes the current industry understanding of value-add and opportunistic strategies. The implication is that the use of the words now describe a mish-mash of variables rather than being based around return as was previously the case.

INREV (the European Association for Investors in Non-Listed Real Estate Vehicles) developed its first definitions of the different risk categories back in 2004. It used leverage and return to classify non-listed property funds as core, value-added or opportunity.

For core funds the return expectation was 5 percent, for value-add it was 5 percent to 25 percent and for opportunistic the return was 25 percent and above.

By 2011, the sophistication of the industry demanded that these were updated.

So, the style classification became based on a bundle of risks. Today, the INREV Style Classification focuses on three factors that are found to be the key determinants of fund style.

These three factors are: target non-income producing investments; target annual development exposure as a percentage of fund gross asset value (GAV); and maximum allowable leverage as a percentage of fund GAV. In addition, a core fund must target most of its return from income (see figure 1).

Yet, despite INREV's best intentions, today the lines are still blurred, especially across geographies.

To correct this confusion in the market place, INREV is currently working with its sister organizations, ANREV (the Asian Association for Investors in Non-Listed Real Estate Vehicles) and NCREIF (the National Council of Real Estate Investment Fiduciaries) to produce a worldwide rule of thumb.

Maurits Cammeraat, a director at INREV, says: “We are in the first stages of developing a global style framework. In a globalizing real estate industry it is really important to come up with a single global definition of what is core, value-add and opportunistic.”

“In reality though, when managers market for specific funds, they typically use the same words but they have a different meaning. Also, if you talk to other asset classes, they don’t have the same style frameworks. So we have been discussing how to align our style with other asset classes to make life easier for investors from a non-real estate background,” he adds.

Many commentators are in agreement that, since the global financial crisis (GFC), the definitions have changed and could even be in a constant state of flux.

“While where you are in the cycle may have an impact on the definitions of value-add and opportunistic, I think the financial crisis itself has had a pretty significant impact on these distinctions,” says Edmund Craston, managing director of Rockspring Property Investment Managers, the London-based real estate investment management firm.
“Many opportunistic strategies suffered badly during the financial crisis and I think it probably led opportunistic investors and managers to reappraise how they present the strategies and how they take risk.”

Diminishing returns

Craston believes this has led to a shift in the perceived returns expected from opportunistic vehicles.

“Pre-GFC the opportunistic mantra would always be to target 20 percent-plus returns, I would say the figure is often a high teen number now,” he says.

There also seems to be greater importance placed on equity multiples, he says.

“You can have very high internal rate of return (IRR), but a very small equity multiple because you have such a short period. Investors are more aware that they need to think about the equity multiple,” Craston says. “A value-add and an opportunistic strategy may have similar equity multiples but the opportunistic one may offer higher IRR because of the quicker turnaround.”

Some voices in the industry think the delineation remains distinct as Rob Wilkinson, chief executive officer of investment manager AEW Europe, points out.

“The terminology is misused and abused,” he says. “Personally, I think the definitions of each type are quite clear. Simplistically, the answer is in the name.”

“An opportunistic fund should be seeking to invest in a situation where there is a particular characteristic such as the type of asset or the capital market, which represents an interesting opportunity,” he says.

“Core investors want something with a long lease, undisputed location, high quality tenant and quality of building. So value-add should be focusing on an asset where one or two of the above factors are present, enabling you to acquire it at a different level of pricing and sell it back.”

While others disagree that the interpretations have changed, and even suggested that individual strategies should not be categorized so regimentally.

“Value-add is really anything you can add value to without doing development, and opportunistic is distressed or development. I’m not really so sure these definitions are changing,” says Audrey Klein, head of equity at Valad Europe. “I’ve never been a great fan of putting these strategies in a box. The definition between core-plus and value-add is a very fine line, it’s really how much work you have to do.”

Risky business

So if the characteristics of what is definitively value-add, can move along the risk spectrum, it poses the question about what risks fund managers and investors see as tolerable and intolerable in the current climate.

The London-based fund manager quoted at the start of the story says that the key risk to consider when undertaking a deal is exit potential. “Can we exit in a downturn?” he says. “When we look at liquidity and the market, we would rather take a low return but with a greater chance of exit,” he continues.

Other types of risks that are factored in by fund managers include planning, construction and fiduciary. “The more of those you have on the higher end of the risk spectrum, the more you are heading towards opportunistic,” the fund manager adds.
Craston, who previously worked at Lehman Brothers and UBS, says: “For us, in simple terms, in a value-add strategy four or five years ago, we probably invested in a narrower geographic focus than we do today, which is probably a reflection of growing confidence. But there are places we would still be reluctant to go, say parts of Eastern Europe, which opportunistic managers might be willing to.”

“We will probably take less operational risk than an allocating opportunistic manager. They are more exposed to operating businesses and their returns. We like income as a component of our returns, income streams that we grow and enhance,” he adds.
Wilkinson says his firm is focused on more macro factors when assessing the relative risk of a strategy or market.

“Geopolitical risk is a no-no. Geopolitical issues will decide whether we actually look at a market, and then after that you take other factors like transparency, rule of law, liquidity and size of market,” he says.

“Because real estate pricing has moved so significantly since the crisis, people have started to look to other areas that might be higher up on the risk curve than they were before.”

Given the difference of opinion and contrasting interpretation of the strategies, the impending definitions from INREV cannot come any sooner.