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Real Estate Funds: "open season" for institutional investors

One of the prevailing trends in the current real estate fundraising cycle is the high number of perpetual-life and open-ended funds entering the market. What are the reasons behind this trend and what are the advantages and challenges of these types of fund, both to fund managers and investors? 

Traditionally, open-ended vehicles have been most frequently used for core and core-plus strategies. However, managers are increasingly utilising open-ended vehicles for strategies targeting a higher rate of return, including strategies with a larger value-add or opportunistic component and asset class-specific strategies, such as hotels funds, which have previously been served by closed-ended vehicles. This has resulted in a proliferation of funds in the market that are best described as being hybrid or semi-liquid open-ended vehicles, both in terms of their return and liquidity profiles. 

Advantages of open-ended funds

Real estate fund managers are increasingly favouring these hybrid open-ended vehicles for the following reasons:

  • institutional investor demand for these products is clear. Institutional investors still want long-term exposure to assets but are seeking higher returns than those provided by traditional core strategies or by REITs; 
  • closed-ended vehicles impose a short, defined fundraising period during which managers have to close all of their capital commitments from investors, and a commitment period outside of which the investors’ capital cannot be invested. These considerations do not apply to open-ended vehicles, so fundraising and capital deployment is more straightforward;
  • by the same token, managers of open-ended vehicles are not tied in to having to return capital by a fixed date at the end of the fund’s life. This allows them greater flexibility when deciding to hold on to, or dispose of, the fund’s assets. However, the underlying assets will typically reach a point of stabilisation after which total return decreases, as they have moved through the growth phase and into the yield-producing phase. Managing this transition for open-ended vehicles (as opposed to closed-ended vehicles, which would simply sell the asset at the high growth point) is a key consideration for these funds, as it will require an active decision to hold or to sell; and
  • the open-ended model allows investors to recycle their capital through one vehicle, rather than being required to re-commit to, and re-negotiate the terms of, a new closed-ended fund vintage every two-to-three years. 

What are the challenges of open-ended funds and how are these mitigated?

The most obvious challenge with any open-ended real estate fund is the inherent tension between offering liquidity options to investors where the underlying assets are fundamentally illiquid. 

Managers deal with this by imposing redemption queueing procedures, redemption limits, and by providing for a relatively long timeframe on their obligation to meet redemption requests, in the fund documents. Investors accept the need for these restrictions in order to ensure exits can be managed in an orderly fashion without adversely affecting the remaining investors or triggering a fire sale. We have also seen managers explore the means of offering liquidity to investors through the use of more traditional REIT structures and lately through digital exchanges and the ‘tokenisation’ of fund interests. 

Another related challenge for open-ended vehicles of this nature is that the desire to move higher up the return spectrum conflicts with the income- or yield- generating characteristics of the underlying assets. Open-ended vehicles have traditionally offered a regular income stream, which is attractive to investors. A desire to produce increased IRRs may well bring other challenges, including less consistent cash flows, which may be less attractive for investors. 

Fund managers and investors will need to keep an open mind about the use of hybrid or semi-liquid open-ended vehicles for real estate strategies with a higher target return and whether these funds can survive continuing pressures on liquidity. Otherwise, investors may call time on the “open season”, following which we are likely to see a return to conventional closed-ended vehicles.

Explore further topics across our UK Real Estate Horizon Scanning 2020 publication.

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