For over a decade, direct real estate has gained an increased presence in the portfolios of Canadian pension funds. After the Great Financial Crisis, real estate allocations have increased further for many sponsors as they continue to search for higher returns and benefits to diversification in the current economic environment. Larger public pension funds have the in-house expertise to make the careful investment decisions to maximize returns as well as the size and scale to enter into transactions that may be accretive to their overall portfolios. Small pension funds, on the other hand, do not have these resources and thus face a different set of issues that require a different approach.
Smaller pension funds are more reliant on external fund managers and a closed-end limited partnership with a value-add investment style is often used to access direct real estate. Understanding some of the basic issues surrounding this particular type of fund structure and investment style will help pension fund investors more effectively monitor their advisors. Meetings typically take place on a quarterly basis, and it is during this time that an institutional investor can ask the incisive questions necessary to hold their advisors to account and ensure that the fiduciary duty to beneficiaries is truly upheld.
The capital call
A critical aspect of the limited partnership agreement is the legal obligation of limited partners (LP) to provide capital whenever called by the general partner (GP). Typically, limited partners must hold their cash in an interest-bearing account and deliver through wire transfer with sufficient notice by the GP in order to fund acquisitions and address ongoing capital needs such as leasing commissions, tenant improvements and capital expenditures. Though this is often a consensual process, limited partners should bear in mind that they are legally committed during the pre-defined investment period. If there is disagreement or a reluctance to provide capital, the LPs must defer to the GP. One of the most noteworthy examples occurred in 2009 when a notable real estate private equity fund in the United States wrote down investments it made between 2007 and 2008 by over 40% and still called capital to the dismay of the LPs who were dealing with their own liquidity issues at the time.
You’re more liquid than you think
A commonly held view of private equity investing through an LP structure is the long-term commitment a limited partner must make. On top of the relative illiquidity of the real estate asset itself, a drawback often cited is that limited partners have their money ‘locked up” during the pre-defined investment period. While this is true in many cases, there is a growing secondary market for limited partners who want to exit their position before the end of the fund’s life. Though it is comforting to know this option is available, there are important caveats to bear in mind (among others): (1) the secondary market is still relatively young and (2) pricing can be difficult due to the particular features of the LP structure holding the assets.
The importance of covenant strength
The value of real estate is partly derived from the stability and quality of cash flows from its roster of tenants. The ability of a tenant to meet its lease obligations (namely the monthly rental payment) is often referred to as its “covenant”. On one end of the spectrum is a government lease, which is essentially regarded as a bond. On the other end of the spectrum is a new company, such as a start-up that is in a precarious financial situation and may no longer be a going concern in the near future. Somewhere in between these two extremes lies most covenants and an in-house capability to assess them is crucial. Though credit reports can be ordered for publicly traded companies, many tenants are private and determining their creditworthiness requires an individual who is comfortable with the particulars of financial statements. If your advisor is entering into a sale and leaseback deal, which is typical in an environment with compressing cap rates and stable rental rates, the covenant of the tenant is paramount and therefore central to the deal. Ensuring that at least one person on an investment team is critically evaluating a tenant’s financial health will help to ensure cash flows from your real estate portfolio are stable and reliable.
Disposition timing is key
If things go as planned, your advisor will have successfully executed on its value-add strategy and achieved – or even exceeded – its target return for its portfolio of assets. Unfortunately, this doesn’t always happen and there could be some “challenged” assets that remain in the fund as it closes in on its anticipated wind-down date. Whether it’s a bankruptcy in a single-tenant industrial building, the unexpected departure of a prime tenant in an office building or a failed strategy to reposition an asset, these issues can cause assets to haemorrhage red ink and hamper the overall performance of the fund.
Though there may be a temptation to sell off a stabilized asset on schedule, its role in the overall portfolio of keeping it cash flow positive is particularly important. Portfolio scenarios (i.e., a one time major cash outflow such as a roof replacement or a credit facility that has been stretched to its limit with no more equity to call) can result in a situation where the carrying costs of those challenged assets may be too much to bear. Exacerbating matters further is the inability to service debt, an important part of the value-add formula, possibly resulting in foreclosure. Sponsors should never view assets on a stand alone basis: often, one asset is cross-subsidizing another making the timing of dispositions more complex than it appears.
Understanding recourse debt
Though the cost and amount of debt are typically scrutinized when assessing impact of leverage on a property, the terms of lending are just as important. And perhaps no other term of lending matters more than the recourse clause. For those new to mortgage financing, the recourse clause permits the lender to go beyond the confines of the property in order to recover any shortfall in its principal repayment. This essentially gives the lender access to the fund and compromises the security of the other assets it holds. Non-recourse mortgages restrict a lender’s access beyond the property it is charged against thereby protecting the fund from any unmet liability. If the fund agreement restricts non-recourse mortgages, acquisition officers and investment committee members should be acutely aware of this before shopping or assuming mortgage financing. Though this is certain to be addressed at some point during the due diligence period, it may only come into focus after incurring deal-pursuit costs such as legal counsel, environmental/physical consultants and your acquisition team’s valuable time. It is worth mentioning that barring any restrictions against recourse mortgages, there is nothing wrong with this term as long as the implications and compensation for incremental risk it represents are well understood.
The pressure to buy
A closed-end LP fund typically has the following overlapping investment timelines: twelve months to raise equity, three to four years to place that equity, seven years to add value resulting in a total life of approximately ten years. In a fairly frothy market, like the one we’re seeing right now, deal making can be difficult as competition for real estate assets is intense. As a result, your advisor may be tempted to place as much equity in one fell swoop if the right deal happens comes along. While this may seem like a convenient way to meet the investment deadline, you may be sacrificing a meaningful level of sector and geographic diversification. Discretionary funds only need to gain approval from their investment committee to do the deal, not the client itself (hence the name of the fund), so lessons from this kind of investment decision may only be learned after the fact. A thorough investment policy that sets limits on concentrations can address this issue as well as an incentive fee based on performance (as opposed to a fee structure that includes an acquisition fee for example).
Honouring the process
In an era of heightened vigilance and stricter oversight on investment decision-making, the integrity of the investment process is more critical than ever. From the sponsor’s perspective, it is important to confirm that such a process exists and is honoured by those who have put it in place. Though sometimes onerous for the advisor, a thorough investment process imposes a level of rigour that prevents rash decision-making. Additionally, it should foster conditions whereby advisors are constantly asking how the assumptions imbedded in their valuations for acquisition and disposition would be received by the investment committee. An on-site file review of documentation covering the entire investment cycle is one of the most effective ways gauge an advisor’s adherence to the process and the quality of analysis used for decision-making.
Preparing for the worst
Having a plan in place in the event of a significant economic slowdown or a severe systematic shock akin to the 2008 financial crisis should be part of an advisor’s fiduciary duty. While it may be easy to meet return requirements during a period of compressing yields, real estate’s cyclicality requires a strategy for advisors to withstand downturns, minimize losses, and hopefully emerge stronger relative to the competition. This is especially important on four fronts:
- Operations – Encourage property management teams to reduce operating costs and appeal tax assessments. Scale back capital expenditure programs by investing in essential needs and revisit the capital spending program when the market recovers.
- Leasing – Aggressively deal with tenant renewals early on to improve retention and apply a heightened level of scrutiny to tenant covenants to maintain the quality of cash flows. If the downturn is expected to be short-lived, place emphasis on short-term renewals, so the owner – or a future buyer – can re-lease the space at more competitive rate when leasing conditions improve.
- Acquisitions and Dispositions – Restrict prospective deals to primary markets and place greater emphasis on cash returns as opposed to capital appreciation. Prudent underwriting should explicitly reflect existing conditions in the form of rent growth, downtime and tenant inducements. Disposition programs should place priority on stabilized properties and focus on the quality of buyer and its financing arrangements to improve the likelihood of closing.
- Mortgage Financing – Seek term sheets from lenders earlier in the acquisition process and secure financing before committing to the deal. If the fund only requires an aggregate loan-to-value ratio, employ leverage in more financeable sectors (i.e., multi-family) and use more equity in sectors that may carry more risk. This would be the time to exploit other relationships with bank lenders in order to negotiate more favourable lending terms.
This is just a partial list of issues that should be considered when monitoring a real estate advisor. Though advisors have a fiduciary duty, they are fallible and prone to making errors in judgement during the good times and bad times. Smaller pension funds without the necessary resources and in-house expertise can help ensure return requirements are met by asking the right questions before poor decisions (or outright mistakes) are made. Knowing what to ask and anticipating what could go wrong will go a long way towards achieving investment goals that will benefit both parties.
Sadiq Alladina, CFA, is a commercial real estate investment professional working in Toronto.