Typically geared towards institutional investors and high net worth individuals, private equity real estate funds can be an investment option for those looking to tap the property sector.

THE private equity (PE) real estate activity has been gaining momentum since the 2008 global financial crisis. According to CBRE Group, a global real estate services company, the PE real estate industry in Asia-Pacific was worth US$14 billion last year — the highest since the crisis. 

Driven by the demand for opportunities in the region, last year alone saw 42 Asia-Pacific funds undertake fundraising activity — almost double the number in 2013,  — according to CBRE Group. The industry is expected to see more fundraising this year as the region remains a major focus of international investors seeking long-term investments and portfolio diversification. 

According to CBRE, foreign investors who reduced their PE real estate investments in Asia-Pacific, owing to the global financial crisis, are now returning to the region. The recovery of the global economy and excess liquidity in the financial markets have given rise to more real estate investments in recent years while investor confidence, particularly among the Americans and Europeans, has returned.

David Aboud says the excess liquidity in the financial markets, in turn, has flowed into the PE real estate market. Aboud is director of Asian real estate at Guidance Investments Sdn Bhd, which is part of the Guidance Financial Group. The group specialises in developing PE, real estate and fixed-income investment products for institutional investors.

“Arguably, there is too much liquidity in the market. Years of quantitative easing have essentially produced an almost endless pool of money in the world, and a lot of it has found its way into the PE real estate market,” he says.

“In terms of Asian funds, they are more likely to ‘go shopping’ in Europe or the US than in the past. Another trend is institutional funds looking at cross-border deals as part of their search for additional yield.

Examples include Chinese insurance funds and Japanese pension funds.”

While Malaysia’s real estate fund industry is relatively young, many firms see the benefits of being associated with a real estate investment trust (REIT) or real estate fund, given the performance of their underlying properties, says Arjuna Indralingam, executive for mergers and acquisitions (investment) at real estate investment house Zerin Properties.

He has a positive outlook on the real estate fund industry, having observed an increase in the number of real estate firms and the amount of access investors have to indirect real estate. “The landscape surrounding REITs and real estate funds will depend on their performance and the addition of new firms in the market. All this is heavily reliant on the underlying property market, its performance and volatility. 

“Malaysia and its property market have shown resilience in the face of international economic crises in terms of price and rental stability. Thus, rising growth, prices and the ability to shield itself from other market shocks have made the local market favourable to both domestic and foreign investments.”

Targeting sophisticated investors

Although often associated with REITs or even real estate-focused unit trusts, PE real estate funds are vastly different in terms of structure and target investor group. PE real estate funds are low liquidity, closed-end funds that directly invest in real estate assets, thereby incurring a higher level of risk and leverage. They aren’t publicly traded and have a limited lifespan. 

REITs, meanwhile, are open-end, have high liquidity and are easily traded on the stock exchange. And since they behave more like stocks than real estate, REITs experience more volatility than PE real estate funds. 

“[PE funds see] less volatility than REITs because the pricing of their underlying assets is based on direct professional valuations and not market-determined trading prices,” says Arjuna. “There are no requirements of minimum income distribution, like the REITs, so PE real estate funds can acquire and invest in less liquid real estate investments as well.”

While REITs can be as liquid as stocks, investors’ capital in a PE real estate fund will be tied up directly with the assets the fund is investing in. Arjuna says the ability to redeem invested capital is highly dependent on the agreement set forth by the fund, the state of the economy, and the type of property and sector the firm is invested in.

“There is also the associated time lag and red tape involved between the decision to sell a property and [receiving the] distributed earnings and when the sale process is complete, making PE real estate funds much less liquid than REITs.”

PE real estate funds also have higher entry costs. Subscribers tend to be institutional investors, family offices or high net worth individuals, whereas REITs or unit trust funds are open to all types of investors.

According to Aboud, entry levels can be around US$10 million and subscribers, or stakeholders who are called limited partners (LPs), stay invested in the fund for six to eight years. “They tend to be more sophisticated investors, and they get to own a share of the physical assets [that the PE fund invests in],” he says. 

Often, the managers of these funds make LPs an offer to come in and invest their money. In some cases, investors have to fulfil a set of requirements before they can participate in a PE fund, says Arjuna.

The requirements could include financial net worth, income and ability to commit to future capital contributions when the fund requires it.

“However, PE real estate funds are not bound by any requirements to disclose their performance or activities to the public domain,” he says, comparing it with REITs, which are publicly traded and therefore need to be more transparent. 

“[PE real estate] funds might provide information to their board of directors, partners and shareholders, but not to external parties.”

PE real estate funds are governed by a private placement memorandum (PPM) — a document containing the relevant disclosures so that the investor can weigh the risks involved and make a fully informed decision with regard to the investment. All of the funds’ investment stipulations and offerings are laid out in the PPM. 

Investors should note, however, that while the companies operating the funds are licensed by the Securities Commission (SC), PE real estate funds and their activities aren’t. According to Arjuna, there isn’t an actual body — government or otherwise — that is tasked with regulating such funds. However, fund operators can meet with the SC to clarify what the fund does, how much capital it has and the assets it holds.

“Operators of PE real estate funds are not strictly required to divulge the specific fund accounts to the SC per se. Think of it as more of a gesture of goodwill to assure the SC that there are no wrongdoings being committed, and that the fund is stable in nature and not recklessly accepting and spending investors’ money,” he says.

“The SC might validate the information provided by these fund operators by looking at the fund and the operator’s track record to paint as clear a picture as possible about the fund. In essence, the company itself will have to report to the SC, but the fund does not have to strictly provide a detailed analysis of its accounts and activities.”

Different funds will have different exposures to various markets. Funds operating in Malaysia may solely invest in the local market, or they may have a mix of local and foreign properties, depending on the capabilities of the fund operator and needs of the investors. 

Aboud says these funds can also invest in various types of properties, which can be partially or fully developed, depending on the fund’s investment offer documents. “It is a group of sophisticated investors who give their money to a fund operator based on the understanding that you can do certain types of [activities] in a certain period of time.”

While fund sizes vary, Guidance Investments’ current fund in Southeast Asia is aiming at a size of about US$800 million, says Aboud. “Investors like funds at that size or bigger as they have critical mass and can deliver more diversified portfolios.

“[The fund operators] raise the money, buy the assets and manage them throughout the lifespan of the fund. At the end of the time frame, the assets are disposed of and the money returned to investors.” 

The operator also determines the fund’s minimum entry rate, which is typically around US$10 million, says Aboud. When the fund’s assets have been disposed of, the profits — called the internal rate of return (IRR) — are shared between the investors. The IRR typically ranges from 12% to 15%, while annual yields are 7% to 8%.

“Most PE funds have a target [IRR], and it really [depends on whether] the manager has the capability to raise capital [and manage the funds]. There are almost always incentives built into the fees to reward good investment performance,” explains Aboud.

The fees for such funds vary, depending on the fund operator and PPM, but Aboud says there is typically an acquisition fee of around 1% and a management fee.

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on June 29 - July 5, 2015.

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