It is exactly 20 years ago that Prologis stormed into Europe and transformed the landscape of property funds, announcing it had raised $1.07bn of equity for its first European fund. This was a game-changer for the European markets, and not just in terms of size.
The real differentiators were the fund’s characteristics: a 12% internal rate of return, a maximum 50% leverage ratio and a performance fee that saw the fund manager share in some of the profits once a certain return hurdle was reached. Today, we’d call that value add. Back then it acted like catnip for investors.
Funds had already been emerging as the panacea to bring more capital into the property market; the age-old problem of the illiquidity of property was solved by the fact that stakes in funds were much more tradeable than property itself. Not only did that feed into the industry’s own desire to be a more liquid commodity, but it also made property more appealing for investors and rival fund managers.
What Prologis had just done was make that prospect much juicier. Property fund managers had been existing on the annual management fees of core funds. Now, fund managers saw they could get rewarded for their performance – enhancing their usual status with clients – and drive those higher returns through increased debt.
But stop right there if you think this ends happily. The legacy of that exciting time in the market, is not – as it should be – a vibrant and rich value-add part of the fund universe. Instead, it is the rather more sedate collection of funds that have been captured by a new index, the INREV European Open End Diversified Core Equity (ODCE) Fund Index.
These are funds that do everything they can to be the opposite of that first Prologis fund. They invest across multiple countries and multiple sectors and keep leverage below 40%. This is their appeal. By attracting capital from small to medium-sized pension funds, they have grown from around €5bn to €24bn in the last seven years.
The problem was that what Prologis dangled in front of the market was a model in which everyone wanted to participate but that few had the skills to execute at the time. The number of funds went from a handful in the late 1990s to 475 in 2007, and most of them took the Prologis model to heart. This drew an increasing volume of institutional money into the sector, much of it from smaller and medium-sized pension funds that had not previously invested in real estate. Sadly, it was the wrong time to put their faith in a new idea.
As the momentum of the market began to build, the number of value-add funds grew – as did the risks, as leverage and target returns crept up. Even those who wanted to present a core fund model to investors found themselves competing against other core funds that were trying to remain competitive by becoming value-add by stealth.
In 2008, the highest target debt levels recorded for value-add funds were 82%, and 80% for core – figures much more in line with an opportunistic strategy. And with every percentage-point increase in debt, the fund managers moved away from the true skillset they had in real estate, trying to fill the gap with newfound financial engineering skills.
As the global financial crisis hit, those high levels of debt took their toll. Fund performance fell to -26.8% for 2008, down from -2.5% in 2007, driven by the extreme volatility of the UK market. Performance in continental Europe would fall even more sharply in 2009. For many the debt bombs that detonated inside the core and value-add funds were a complete shock. With little experience in running these financial products, fund managers faced problems they had not tackled before.
Many properties were breaching loan covenants, and fund managers had to sit between investors and banks to resolve this, requiring a different kind of skillset and a level of acceptance. Investors who just months earlier had fallen over themselves to get into funds were now crushed. They felt misled, wronged even, by fund managers who had lured them into what now seemed like financial traps.