Manager and investor interest in open-end real estate (“OERE”) funds focused on Asia investments has exploded in recent years, with continued growth expected. CBRE recently estimated that Asia-Pacific-focused open-end funds have investable capital (including leverage) of US$33 billion. Many North American and European investors are poised to increase allocations to Asia-Pacific real estate over the coming years in anticipation that the Asia-Pacific markets will outperform other regional economies. In addition, global real estate investors have increasingly focused on core assets, which are ideally suited to investment by OERE funds.
Open-end fund structures offer several advantages over more traditional closed-end structures, including investor liquidity and flexibility for indefinite fundraising and investment hold periods. On the other hand, real estate investment strategies create challenges for setting up and managing open-end funds that are not present for more traditional open-end funds, such as hedge funds. This article summarizes the key characteristics and terms common to open-end real estate funds, including the structuring and operational challenges that arise and common market solutions.
Traditional Closed-End Structures – Illiquid Investment Program
Historically, private real estate funds have been structured as closed-end funds with (a) a fixed term (8-12 years), (b) a limited period for new investors to join the fund (12-18 months) and (c) no investor redemption rights.
Key reasons for this include that, unlike hedge funds and other “traditional” open-end funds, real estate fund investments are typically illiquid and difficult to value and each investment comprises a significant percentage of the Fund’s overall portfolio.
These characteristics combine to make it more difficult for a manager to (1) readily value the Fund (i.e., “strike NAV”) for purposes of permitting investors to subscribe for and redeem units at a fair price over time and (2) quickly buy and sell new properties as needed to deploy new invested capital and satisfy redemptions requests. Accordingly, the liquidity terms for open-end real estate funds are often more restrictive and highly negotiated than the corresponding terms for hedge funds and other more liquid open-end funds, as we describe below.
Key Open-End Real Estate Fund Terms
OERE fund terms vary from the terms of both closed-end real estate funds and other types of open-end funds in a variety of ways, including, as follows:
1. Investment Strategy; Cash Yield
Most open-end real estate funds focus on “core” investments (stabilized properties in low-volatility markets) that are expected to provide significant current cash yield from rental income. These investments provide cash needed to make regular distributions to investors and also to satisfy redemption requests. In addition, these investments tend to have more stable property values that make it easier to track the Fund’s net asset value (NAV) reliably, allowing for new subscriptions and redemptions at a fair price. Investor appetite for core assets across the Asia-Pacific region has led, in recent years, to heightened competition for such assets due to their relatively low volatility and ability to produce resilient, consistent cash yield.
Unlike traditional open-end funds, such as hedge funds, most OERE funds provide for periodic distributions of available cash (e.g., 3-5% cash yield per annum). This is a key reason why most open-end funds are “core” funds. Investors in OERE funds tend to seek a regular cash yield, similar to a fixed income product.
2. Subscriptions / Capital Commitments
OERE funds generally permit the GP to take in new cash capital contributions (i.e., “subscriptions”) indefinitely over time. A majority of the funds in the market contemplate a fixed schedule (typically quarterly and, less commonly, monthly) for accepting new cash subscriptions. Some funds do not expressly set out a fixed schedule for subscriptions and more generally provide the GP with broad right to accept additional subscriptions at any time.
Unlike a closed-end fund that tracks each investor’s economic rights and obligations (including fee rates) based on its “capital commitment,” investors in open-end funds typically receive “Units” (i.e., the equivalent of shares), at a purchase price equal to the then-applicable NAV per Unit, whenever they make capital contributions; these Units drive the fund’s economics.
A fund may still accept capital commitments in order to provide the GP with certainty of access to dry powder. In this case, investors acquire more Units at the then-prevailing NAV when their capital commitments are called. Accordingly, investors making capital commitments to an open-end fund typically do not have certainty over the purchase price (expressed in NAV) they eventually will pay when paying in capital and subscribing for new Units.
Funds that accept capital commitments often will provide for a subscription “queue,” such that the fund will generally call earlier capital commitments before calling more recent capital commitments.
3. Fees and Performance Compensation
Management fee terms vary substantially across OERE funds, as compared to a typical closed-end fund that would charge a management fee equal to 2% of commitments or invested capital. Globally, the market range varies from approximately 0.5% on the low end to 2% on the high end. Management Fees for open-end funds are commonly expressed as a percentage of the fund’s NAV. Accordingly, the Management Fee could vary substantially if the value of the fund’s assets rises or falls.
OERE Funds are often subject to the same types of asset-level management fees commonly charged for closed-end funds, such as acquisition fees, property management fees, disposition fees and leasing fees.
Performance compensation (i.e., “Promote” or “Carried Interest”) varies materially across OERE funds. Some funds do not charge Promote at all, as the GP’s main focus is maintaining stable target yield and not on developing properties and targeting substantial capital gains.
Most open-end funds that are subject to a Promote will charge a Promote (a) periodically (e.g., once per two, three or five years) and (b) upon an LP’s redemption. The Promote typically will take into account both realized performance (dividends and other distributions) and unrealized performance (increase in NAV) and will incorporate “high water mark” or “hurdle rate” concepts similar to a hedge fund, in order to measure performance against the applicable baseline (initially the LP’s purchase price and, later, the NAV at which prior promote was paid, subject to any target IRR hurdles).
Other types of Promote terms are also seen from time to time. For example, (i) some funds charge performance compensation based on a more traditional “distribution waterfall,” which accounts solely for realized performance, and (ii) others charge performance compensation only on annual cash distributions (i.e., current yield) in excess of a stated target.
Overall, Promote levels are often lower for open-end real estate funds than for closed-end funds, in part because such funds typically manage stabilized properties and implement a core strategy.
4. LP Redemptions
The right to request a redemption of Units is an essential characteristic of open-end funds, including OERE funds. However, because real estate investments are illiquid, the redemption terms of OERE funds are often more restrictive, both contractually and as a practical manner, than for a hedge fund.
In our experience, redemption terms are typically the most highly negotiated terms for an OERE fund, as the right to exit is a key driver for LP demand in these vehicles.
Larger (e.g., $5 billion+), more diversified open-end real estate funds tend to permit redemptions quarterly or semi-annually. Smaller and/or less diversified funds often permit redemptions only annually, though market practice varies substantially.
Often, LPs will be subject to a “lock-up” that prohibits any redemptions for a period of time (typically one or two years or longer in the case of a large anchor investor) after the date of the LP’s investment in the fund. Some funds also will provide for a “soft” lock-up in the form of an additional redemption fee for redeeming Units within a lock-up period.
In addition, redemptions are subject to all of the other standard restrictions for open-end funds, including a “gate” (i.e., the GP is not required to permit redemptions of more than 10% or 20% of aggregate Units in any year) and “suspensions” (i.e., GP is permitted to stop redemptions entirely if there are adverse market conditions or other concerns).
5. Additional Liquidity Protections; Transfer Rights
Investor expectations around how easily their interests can be redeemed vary depending on the size and nature of the fund. For larger, diversified funds, investors may expect that redemptions will be readily available. On the other hand, for smaller, less diversified funds with smaller investor bases, the expectations for availability of redemptions may be lower as a practical matter. In this case, LPs often seek to negotiate additional protections.
For example, unlike other types of private funds (including closed-end real estate funds and hedge funds), OERE fund investors typically have the right to transfer (i.e., sell) their interests in the Fund to third parties, without the GP’s consent unless the transfer would raise special concerns. This reflects a compromise driven by the practical realities of OERE funds. In practice, a transfer right provides LPs with an exit option even when the fund has suspended redemptions due to adverse market conditions. In this sense, a transfer right approximates a “matching” of subscriptions and redemptions (i.e., so that the newly invested cash can be used to satisfy redeeming investors) but empowers the LP to manage the process and find its own direct buyer.
In addition, investors may seek to negotiate requirements that the GP (a) seek to sell one or more of the Fund’s properties if the Fund is subject to outstanding redemption requests that have not been satisfied after a period of time (e.g., one or two years) or (b) set aside (and not distribute to LPs or reinvest into new investments) a portion of available cash for anticipated redemptions. GPs typically resist any requirements to pursue asset sales prematurely or restrict the use of available cash, as a key purpose of an OERE Fund is to hold assets indefinitely and continue to pursue favorable investment opportunities for the benefit of all investors.
Open End Real Estate Funds in Asia have seen substantial growth in recent years, and more capital is expected to pour into the space as global investors seek exposure to Asia core assets. While these types of funds are similar to other open-end funds in the market in many ways, the dynamics of a real estate investment program create challenges and drive significant negotiations. GPs and their investors should focus on the key issues described above in order to ensure that commercial expectations are aligned with the fund’s negotiated terms and the practical realities of an illiquid investment program.