Long-term investors in open-ended real estate unlisted funds could be paying more than double in total acquisition costs if the vehicle uses one pricing approach over another, Willis Tower Watson said in a report Monday.
The global advisory and brokerage firm urged potential investors to allocate to funds using the traditional offer-spread approach, in which the cost of buying a building has been charged against new capital. This methodology, popular for funds investing in UK real estate, leaves the cost of transacting to the investor buying into the fund. Because investors’ capital is immediately diluted, the offer-spread mechanism is not as attractive to short-term investors, London-based Willis Towers Watson wrote.
By contrast, the amortization approach decreases costs for any single year by spreading the purchase costs over a number of years, so all investors bear transaction costs proportionally. That approach is problematic for long-term investors who then pay for part of other investors’ capital in the future, leading Willis Towers Watson to propose that the investor pays more in aggregate by investing in an open-ended fund than if the investor bought the building directly.
In a real estate fund model that assumed neutral (0 percent) performance annually, the firm found that over a 25-year period, investors would pay about 15 percent in aggregate acquisition fees to a fund using the amortization method, versus about 6 percent in aggregate fees using the offer-spread method.
“We believe this is unfair to both early and long-term investors, as well as running the risk of encouraging, for example, more frequent trading,” the firm wrote.
Investment managers have favored amortization because the European Association for Investors in Non-Listed Real Estate Vehicles (INREV) has promoted the approach, and they are finding offer-spread funds difficult to market to investors from continental Europe and the US. Willis Towers Watson countered investors’ interpretation of INREV’s guidance by noting that the industry group’s methodology for calculating net asset value is not intended for pricing new subscriptions.
“Investors are likely to be gaining false comfort from a manager’s interpretation of industry guidance on a fund’s net asset value calculation,” the firm said in the report.
Amortization also incentivizes a short-term investment approach, which managers have tried to avoid by adding exit charges. Willis Towers Watson said this does not entirely ameliorate the issue and still adds volatility to a fund.
“Investment managers should point out the difference between [offer-spread] and the overall costs of the amortization approach to existing and potential investors so that they can assess the difference in cost in order to make an informed decision,” the firm said. “This should overcome any misunderstanding over the actual aggregate cost basis of a proposition and ultimately enable the end investor to be better off.”