Buyers line up for opening of fund liquidation sales season

Private equity players eye assets of 11 open-ended funds facing liquidation, reports Lauren Parr

With SEB ImmoInvest and CS Euroreal the latest – and biggest – German open-ended funds to announce they are liquidating, the sector will bring €24bn of European property to the market by 2017. SEB and CS Euroreal manage a combined €12.4bn of assets and their closure means that as of last month, 11 German open-ended funds are winding up.

Armed with property catalogues extracted from funds’ annual reports, private equity buyers are knocking on managers’ doors hoping to cherry pick assets. Europa Capital, for one, is looking to buy a Hamburg shopping centre owned by CS Euroreal for its pan-European Europa Fund III.

The plight of the funds, which have been hit by redemptions from investors, may present a big investment opportunity, but asset sales will be beset by complications. “It’s a question of pricing,” says Henderson’s German head Tim Horrocks, referring to open-ended funds’ aggressive valuations, which are based on sustainable long-term value, not the mark-to-market approach.

This allowed them to pay favourable prices for stock. In March, Alstria Office REIT’s chief executive told analysts that the average price per square metre of open-ended funds’ domestic holdings was twice as high as its own average – and not because their portfolios were higher quality than Alstria’s. Furthermore, by law, open-ended funds cannot sell properties below their latest valuation, so these will have to come down before they can clear out their stock.

CS Euroreal may already be entertaining approaches about assets, but a wave of distressed sales isn’t imminent due to the five-year liquidation period it and SEB ImmoInvest have been granted – longer than the usual three years due to their large size. SEB is working out its medium-term strategy and has so far sold a shopping centre in Italy to ECE Project Management.

No rush to sell assets

Morgan Stanley analyst Bart Gysens says: “Several funds have announced their intention to liquidate but there is little urgency, as they have three years – and some even five – to do so. Even if some valuations may be overstated, it could take time before reality sets in.”

Liquidations will facilitate this by lifting the restraint on the level at which funds can sell assets: after the first year a 5% discount is allowed and after the second year, 10%.

“At some point this could be a great acquisition opportunity for anyone that wants to acquire offices across Europe and in Germany in particular,” says Morgan Stanley analyst Bianca Riemer. As funds get closer to liquidation, investors are banking on prices falling as they become desperate to sell.

SEB ImmoInvest and CS Euroreal must at least start winding down, as they have to pay dividends to shareholders, in SEB’s case twice a year, ensuring a steady pace of disposals. New rules coming into force next January will force open-ended funds to cut their loan-to-value ratios from 50% to 30% by the start of 2014, which could also increase pressure to sell, Morgan Stanley’s 2011 report The Great Unwind says.

Inevitably, some assets will be easier to shift than others. Typically office-weighted, the funds tend to buy vanilla assets in good locations offering long-dated income, but they also hold plenty of partially vacant buildings. Morgan Stanley says the Dutch office market will be hardest hit, as funds being wound up own offices there equal to the market’s average deal volumes for just over four and a half quarters (see table, below) – more than for anywhere else in Europe.

“We’ve looked at some assets on the market since before [the latest funds’] closure,” says Nic Fox, Europa Capital’s  middle Europe head. SEB has yet to find a buyer for a mall in Hagen, Germany, despite a price cut in the past five months that moves the potential yield from 6.5% to 8.5-9%.

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“Investors are cautious and are being selective about what they buy,” Fox adds. “There is a question mark over the finance-ability and liquidity of some assets, where income is short, for example.”

Many properties are in cities such as Paris and London, where there is still liquidity, while “Germany is flavour of the month,” says Henderson’s Horrocks, adding: “Outside those markets it’s going to take longer.”

SEB may sell some US assets soon, as that market is doing well now, CBRE researcher Iryna Pylypchuk says; Union Investment has been profit-taking by selling selected assets there. Pylypchuk expects sales of more obscure assets in less liquid markets, like Eastern Europe, will come later.

In terms of investor interest, “the world and his wife will be all over this”, says Fox. Trophy assets may be sought by the likes of sovereign wealth funds: earlier this year KanAm sold two of four London buildings it is marketing, to Malaysian investment fund Permodalan Nasional Berhad.

Off-market deals unlikely

Stock needing asset management will be the target of private equity firms and those with a value-added strategy, such as Europa, “if we can stomach the competition”, Fox says. “It’s highly unlikely to be dealt with in a ‘rifle shot’ style, off-market.”

Pylypchuk predicts €5bn-6bn of deals  per year, but says the effect on Europe’s investment markets will be minimal, as the €24bn of sales expected from open-ended funds is only around 5% of the €400bn- 500bn of trades forecast for the next five years. It should not be enough to push down pricing in most markets, she believes.

There has been scepticism about the quality of open-ended funds’ management, valuation methods and adequacy of diversification since 2005. But it was the credit crunch that led to liquidations, by revealing their structural flaw: a liquidity mismatch. The sector offered daily liquidity (despite investing in large, illiquid assets), so institutions used it as a way to get better returns than letting money sit in the bank.

Institutions were not subject to the 5% commission private individuals paid to withdraw money, so when the market started to plummet in 2008, they redirected their capital to address liquidity problems in other parts of their portfolios. The open-ended funds model, not designed to withstand frequent and volatile withdrawals, cracked under the pressure of rising redemptions.

From next year, investors will have to wait 12 months before taking back their money. But institutions have already moved money from open-ended funds, which are no longer attractive for them. A survey last month of 45 institutions by Scope Analysis found that only 20% of respondents were interested in German open-ended funds, down from 60% in a previous survey.

“An additional risk is that liquidations and  negative asset revaluations get written up in the German press and other funds’ investors  try to withdraw money,” says Riemer. “Funds with a significant retail investor base and large distribution networks have withstood that tide so far. Whether they will be strong enough to do so in future is unclear.”

Observers and managers say bank-owned funds will survive, while others are likely to struggle. The likes of Union Investment and Deka (part of savings banks) will continue, while the survival of Commerzbank’s fund depends on how the group sees its future, having accepted German government aid.

Deutsche Bank is still in talks with US institutional asset manager Guggenheim Partners over the sale of RREEF, so it may not have a distribution network available in future – something that scuppered Aberdeen’s acquisition of DEGI’s funds.

Institutions are temporarily investing in property shares instead of German open- ended funds. But as they favour very safe, low-yielding investment products, in the long term they will look to invest in other real estate funds or spezialfonds; the latter are designed for non-retail investors.

“Institutional capital is shifting out of  the sector and some is clearly going into spezialfonds,” says Pylypchuk, who estimates that the sector has grown by more than €10bn in the past four years, to €33.5bn, in sync with open-ended funds’ decline. It is expected to grow by a further €10bn-15bn by 2017.

Spezialfonds give institutional investors a greater role in strategy and decision making. They are smaller, sector-focused vehicles and behave more like closed-ended funds, despite being open-ended. But many of them are so focused that they may own just one or two assets; IVG’s EuroSelect 14 fund is only invested in The Gherkin, for example.

“On top of that, existing and new fund managers are launching vehicles,” says Pylypchuk. Union Investment last year launched a shopping centre spezialfond, called UII Shopping Nr1.

But risk-averse retail investors have little alternative when it comes to investing in Germany, which lacks a private pension system, so open-ended funds help people save up for pensions. “Open-ended real estate funds remain the most attractive form of indirect property investment for small investors,” says Reinhard Kutscher, chairman of Union Investment’s management.

So the sector will survive, but with “a smaller pool of focused, successful funds, more driven by retail capital”, Pylypchuk says. “These will benefit from strong inflows.”

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Net inflows from December 2011 to February 2012 totalled €1.5bn, reinforcing Pylypchuk’s conviction that “the sector won’t die. There are two elements: longer-established funds and those created in the boom, which are having difficulties, as the majority of investment came from institutions.”

A select few potential buyers

While the sector will undoubtedly shrink,  acquisitive managers have a chance to mop up the assets shed by liquidating funds.

“Liquidations might open doors, but few have a strong enough capital base to benefit from sales, especially in property sizes above €100m,” Kutscher says. He adds that Union Investment could be one of these few, “if the quality and prize is right”.

The likes of RREEF and Deka, supported by distribution networks, will also be in the market for such assets, while spezialfonds may be interested in absorbing open-ended fund assets in the €20m-40m range.

With the healthy open-ended funds getting stronger and spezialfonds attracting recycled and new capital, Germany’s open- ended funds are set for a period of consolidation. Liquidations do not sound the death knell for the sector, as funds have proved themselves capable of reform, says Kutscher.

“New legislation next year to strengthen investor protection and improve the operation of capital markets will see open- ended real estate funds revert to their classic role as a low-risk product for a broad cross-section of private investors,” he says.

Sales may be only exit route as funds reach end of road

Liquidating German open-ended funds are stuck with the tag ‘forced seller’. They cannot postpone all disposals until the third year of their allotted disposal period (the fourth or fifth for bigger funds), so some are looking to transfer assets into new structures, rather than sell them in the open market.

This model has been tested in countries such as Australia and Holland. In the latter  it was the route by which Rodamco listed. “The equity market offers a potential exit by converting units to shares, which investors are usually offered at a discount,” says Morgan Stanley analyst Bart Gysens.

But the German government rejected EPRA’s lobbying to allow open-ended funds to become quoted vehicles. One of the main conflicts is that listed companies are very transparent, unlike the funds. Another is opposition from key stakeholders looking to redeem at net asset value, when the listed sector typically trades at a discount to NAV. Managers are also reluctant to forfeit fees in favour of an internally managed company.

Henderson’s Tim Horrocks adds: “Managers will come under scrutiny if they try to re-siphon assets from a fund that is being liquidated into a new product launched by the same manager.” His gut feeling is that most assets will be sold in the open market.