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.

Fund selection criteria

Aboud recommends choosing funds that have a good standing and track record. While some funds may invest in foreign assets for diversification and better returns, issues and risks associated with currency exchange and interest rates will arise, so fund operators must understand the markets they are operating in.

“I would avoid funds that are run remotely by parties who have a poor understanding of the market they are investing in. Real estate is about understanding the market and location. If you want good returns, you should get a fund operator who is in the market and understands it,” Aboud says, adding that the quality of the fund operator is an important criteria.

“Look at the quality of the fund operator. A good fund has experienced people who understand their markets and have been there for some time. Track record is another good indicator.”

Like with many other investments, selecting a fund to invest in depends on one’s risk appetite. Risk-averse investors seeking stable returns should look for funds with lower levels of risk while those who are risk-takers can seek out funds with higher risk and returns. 

According to Arjuna, one criteria to look at is the fund’s gearing level, which is stated in its PPM. A high level of gearing might allow funds to invest more aggressively, but it will expose them to greater risks given the fluctuations in interest rates and market conditions.

“And vice versa for funds with low levels of gearing. The use of leverage shifts the focus away from income [generated] and towards capital gains,” he says.

“Lastly, the types of properties in the fund, their occupancy rates and locations are factors that could affect the income generated by the properties, which would directly impact your returns as an investor.”

Overall, the selection criteria for a good PE real estate fund doesn’t stray too far away from the fundamentals of property investing. Aboud says one should go for good quality assets in good locations and pick sectors that have limited supply and strong demand.

“This generates rental growth, which yields higher values and better performance for the investment. There is a search for yield right now among the funds across the world,” he adds. 

“Before 2008, there was quite a bit of money looking for high-risk developments — those you can buy and reposition, or flip quickly and drop. But now, investors are focused on strong, fundamentally sound properties with good yields.”

Aboud sees more money being invested in Asia, particularly in Southeast Asia. This will be driven by the region’s high savings rates and growing middle class.

“Southeast Asian sectors that will do well are those that grow from a young demographic, strong consumer demand and middle class, so the retail, logistics and residential [sectors] will be strong,” he says. 

Education and logistics are becoming popular sectors, he adds. “A strong young population and cultural preference for education means parents will accumulate education savings for the younger generation, while a rising consumer base combined with e-commerce trends will drive logistics. The healthcare sector will expand as well, spurred by a growing middle-income group.”

Hence, property funds looking to ride these trends will invest in university campuses, logistic warehouses and hospitals. “This applies to Malaysia and many other Southeast Asian countries. I would avoid high-end residential properties in central business districts for now as they are fairly oversupplied,” says Aboud.

In Arjuna’s opinion, investors with a high-risk appetite can consider funds invested in Southeast Asia and the BRIC nations (Brazil, Russia, India and China), as opposed to funds that minimise risk by investing in developed nations. 

“If a fund is ready to accept higher levels of risk with the promise of higher returns, it should look at developing nations where markets are less established but there is substantial room for development,” he says.

“Markets like Brazil, Turkey and Indonesia offer higher returns at the cost of higher risk. So, this is heavily dependent on the level of risk a fund is willing to expose itself to. If it is trying to minimise risk, a fund will generally stick to the more established markets in Europe and the US.”

Arjuna favours office buildings in central business districts; the medical and healthcare sector, which is riding the high demand for good quality private healthcare solutions; and the hospitality sector, which is seeing higher tourist arrivals and more competitive regional pricing.

PE real estate fund strategies

Private equity (PE) real estate funds can be classified by the type of investment strategies they use — Core, Core Plus, Value Added and Opportunistic. According to Arjuna Indralingam, executive for mergers and acquisitions (investment) at Zerin Properties, the type of assets in a fund’s portfolio is usually an indicator of the fund type.

Core funds 
Funds that adopt a Core strategy are at the lower end of the risk spectrum. They generally acquire and own properties that have low-to-zero vacancy rates, various tenants (with long leases and rental contract agreements), and properties with stable and guaranteed cash flow in established property markets and sectors. 

The focus of Core funds is on rental income and less so on capital appreciation. Relative to other types of properties held by funds, Core funds are usually made up of highly liquid properties that can be easily disposed of. Investors with a low risk appetite and looking to minimise their risk exposure tend to invest in Core funds.
 
Core Plus 
Core Plus funds take on a slightly higher level of risk than Core funds. The properties in the portfolio of a Core Plus fund have pretty much the same characteristics as those in Core funds, which is good quality properties in established markets. The difference between the two funds is that some properties in Core Plus fund might need a refurbishment or refit exercise to maximise their value.

Value Added
Value Added funds assume more risk than Core and Core Plus funds as they acquire properties at a discount-to-replacement cost or lower than market value. Properties could be distressed and in need of a complete refurbishment or refit exercise, or a change in the management of the property, before their full value and income stream can be realised. 

Value Added funds generally aim to increase the overall value of the property over the original acquisition price (capital appreciation) rather than focusing on a stable income stream (rental income). The properties in a Value Added fund do not necessarily have to be distressed properties or in less established markets. These funds could hold properties with Core-like features but lack the key features of Core properties, such as low-to-zero vacancy rates and multiple tenants. Properties of Value Added funds are more likely to require a marketing and leasing exercise to raise occupancy levels.

Opportunistic
Opportunistic funds assumes the highest risks among the fund types. They seek out events in the market that they can capitalise on and reap high returns from. Such funds do not limit themselves to acquiring existing properties and get involved in the development aspect of real estate, such as building properties from the ground up. 

Opportunistic funds typically assume a substantial amount of leverage in order to fund the investment opportunities that are not immediately profitable, but have good future or long-term prospects. The added risk of utilising leverage is that the fund and its investors are subject to the risks associated with fluctuations in interest rates. Investors who are risk-takers are likely to go for Opportunistic funds as they would get much higher returns than those offered by other types of funds.

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

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