In a Shifting Market, Real Estate Funds Face New Realities

Signs of improvement continue to build in the real estate markets, although slowly. Global deal activity and property values are still significantly below peak levels, and the recovery is expected to take a gradual rather than a rapid course. But for investors and fund managers, this may actually be the ideal environment in which to deploy capital.

The landscape in which real estate private equity funds operate is changing, however, and these changes are directly impacting their terms and operating models. The state of the market in the aftermath of the financial crisis, especially given the continued challenges in capital-raising , has empowered investors to make greater demands of fund managers. Increasingly, investors are applying pressure over terms and fees and demanding more frequent and transparent reporting.

As a result, the pre-crisis standards for deal terms and fees have altered considerably, and fund managers are feeling pressure from investors to make modifications to fit new industry norms. Our recent survey indicates that this is especially true for new and small to medium-sized funds. Overall fund periods have shortened by an average of two years since 2007, while average investment periods have scaled back from four to three years. Preferred returns have dipped slightly, but target levered returns have dropped to the high teens, compared with the 2007 norm of more than 20%. In addition, funds increasingly are pooling returns instead of offering them on a deal-by-deal basis. While carried interest still follows the standard 80/20 structure, limited partners are demanding more favorable distribution. They are also demanding more meaningful cash commitments from general partners.

Funds’ fee structures are also under scrutiny from investors, who increasingly are challenging fund managers for better disclosure of acquisition, asset management and disposition fees, along with calculation methods for performance fees and internal rates of return. Indeed, 39% of funds polled in the survey said investors were demanding more frequent and transparent reporting while 43% said they had modified or suspended fees.

But for many, investors’ heightened transparency expectations will soon be matched by regulatory requirements. Of the legislation affecting funds, the Dodd-Frank Act will have the greatest impact on funds in the United States, requiring SEC registration for many private equity fund advisors with more than $100 million in assets under management. To comply with registration requirements , the advisors will have to hire compliance officers, establish and maintain a compliance program and conduct annual program testing. They will also be subject to SEC audits.

In the face of tightening regulatory requirements, funds will have to cope with substantial compliance costs while experiencing pressure to maintain or reduce fees, including management fees. To offset these costs, many fund managers will have to find ways to improve business efficiency. One growing trend is outsourcing back-office operations such as bookkeeping and administrative functions. This has been a cost-reduction strategy among hedge funds for some time, but it is now becoming common in the real estate space as well.

Beyond the challenges and costs that will arise in the new regulatory environment, the possibility of large-scale reforms of accounting standards also looms on the horizon. The new Financial Accounting Standards Board proposal, if passed, would require funds to report real estate assets as investment property and to measure property at fair value, bringing the generally accepted accounting principles of the US in line with International Financial Reporting Standards. Real estate funds would also be required to provide detailed information at the consolidated level for assets in which they hold a controlling stake. This would include rental income, real estate taxes, operating expenses and property level debt.

Meeting these accounting standards, as well as forthcoming regulatory standards, will be costly and time-consuming, especially for small and medium funds. The upside is that greater transparency and stronger controls could also offer an advantage in raising capital, particularly in the near term, since investors are likely to continue taking a cautious approach to how and where they place their capital. Greater transparency in funds’ reporting would not only help investors better understand individual property risks but also enable them to compare funds side by side.

There is still a substantial amount of capital sitting on the sidelines. Funds looking to be the most competitive in attracting investors will have to adapt to the new transparency and controls requirements, especially if they hope to seize new opportunities as more distressed assets become available over the next several years.

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Howard Roth is the Global Real Estate Leader and a partner in Ernst & Young LLP’s Real Estate practice. He may be reached at howard.roth@ey.com. The views expressed here are those of the author and do not necessarily reflect the views of Ernst & Young LLP or GlobeSt.com.