Although there’s consensus on clouds hanging over private real estate markets while some investors here still face a rough ride, instability in the market for Real Estate Investment Funds, known as REIFs, - unlike the European Central Bank - is not seen as an immediate systemic threat to the real economy, according to real estate specialists in Luxembourg and London.
A deteriorating outlook and declining valuations in the international real estate market has inspired researchers at the European Central Bank to take a closer look at real estate investment funds, especially open-ended ones, which can be traded pretty much at any given moment and therefore redeemed relatively swiftly. Luxembourg, along with a handful of other EU countries, is a leading hub for such funds.
Open-ended REIFs account for some 80 percent, or 835 billion euro, of the net asset values of all European real estate funds. It’s also a market that has become increasingly relevant during the last ten years. In Luxembourg alone the number of funds has risen nearly threefold, to 621, between 2012 and 2022. Asset values surged five-fold, to 127 billion euro.
“There are clear signs of vulnerability in real estate markets, including declining market liquidity and price corrections, driven largely by uncertainty in the macro-financial outlook and by monetary tightening,” concluded ECB researchers in a study published on Monday.
Policy framework needed, say ECB researchers
To address “structural vulnerabilities of REIFs” and the “risks they pose to CRE markets and wider financial stability”, the ECB researchers have recommended establishing a policy framework to address these issues, in particular handling spikes in liquidity demands, internalising the costs of redemptions, while reducing the underlying liquidity mismatch. CRE is industry-speak for Commercial Real Estate.
Real estate specialists at EY in Luxembourg see a clear role for the industry itself. A “response to these challenges should not be expected to come exclusively from policymakers but is also driven by the market,” said EY’s Norman Finster and Pierre-Alexandre Coipeault in a written answers to IO questions.
“There is a considerable heterogeneity of CRE markets with very different dynamics and responses to demand driven shocks. It is therefore critical that policymakers recognize such diversity and leave significant flexibility to REIF sponsors to not overly constrain structuration,” said EY’s real estate fund experts.
The ECB calculated that on a European level, the value of REIFs’ real estate assets as a proportion of the total value of the euro area commercial real estate market increased from 20 per cent to 40 per cent during the last ten years, highlighting the growing importance of REIFs for this market.
‘No panic’
At Janus Henderson in London, Guy Barnard, co-head of global property equities, said he was not surprised to see the ECB draw this conclusion. He noted however that there is “no panic” in the market. Janus Henderson only invests in listed real estate funds, with a 4 billion dollar portfolio, and not in open-ended funds that hold physical buildings. The main benchmark, the “gold standard”, for assessing real estate market values is the FTSE EPRA Europe Index, which has declined 36 per cent in the twelve months ending 31 March.
“Asset prices are ageing towards reality,” Barnard said, adding that this adjustment also needs to be reflected in the less-liquid REITs such as those discussed by the ECB. “Public markets lead private markets by a different beat, by 3, 6 or 12 months. Investors need to be very selective.”
Moving forward in a weak market, Barnard sees a particular risk in funds that have invested in lower quality real estate, or with heavy exposure to retail. You don’t want to find yourself owning a fund that does not pay dividends because there are no tenants in its properties, he said.
Cross-border nature
ECB researchers also expressed concerns on the cross-border nature of real estate investments, especially in products such as open-ended REIFs. “These cross-border investments increase the interconnectedness of euro area CRE markets, with the risk that stress in one jurisdiction might spill over to CRE markets in other jurisdictions.”
“The importance of REIFs and their potential to amplify CRE market dynamics is particularly concerning in light of growing vulnerabilities in the CRE market itself,” said the ECB study. “Vulnerabilities in the CRE sector are widespread across the euro area, but the outlook for countries with a pronounced REIF presence does not appear favourable.”
Despite the cross-border nature of the market EY believes that Luxembourg REIFs are more resilient compared to funds in other jurisdictions. The “investor base of Luxembourg REIFs is largely European and therefore usually less sensitive to exogenous redemption shocks,” it said.
Furthermore, it underlined that the REIF industry in Luxembourg in recent years has seen a “significant shift” towards strategies that bring diversification, enabling managers to better manage their risks. EY also pointed out that Luxembourg REIFs are often structured with redemption gates and other liquidity management tools and have proven to be resilient during COVID crisis, with very few suspensions.
“However, current challenges related to raising interest rates and uncertain economic outlook must be taken seriously, in particular by managers of open-ended funds who need to adapt their investment style and portfolio construction to the evolving market conditions but also carefully assess, test and anticipate risks related to liquidity mismatches,” said EY.