Illiquid assets

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GLOBAL INVESTOR 1.15 — 46 03_Real estate transaction process A typical transaction process for commercial real estate consists of five steps and may last up to six months. Expenses, such as search or transaction costs, may incur at each step. Steps 2, 3 and 4 could run simultaneously. Due diligence thus makes up most of the time and costs. Source: Credit Suisse Research – Search costs – 2–4 weeks Swiss real estate funds has been 7% since January 1990. Direct real estate investors can avoid this premium. In addition, although direct real estate cannot be traded on a daily basis, this may be a good thing from a behavioral finance perspective. Most investors tend to underestimate transaction costs and in turn reduce their performance by trading too often. Since the real estate transaction process takes time, investors are automatically prevented from excessive trading. Preliminary check and non-binding offer – Agency costs – 1–2 weeks Negotiation and final offer – Negotiation costs – 2–4 weeks Due diligence – Market, legal, tax, technical and environmental due diligence – 1–3 months Closing – Additional costs (transfer taxes) – 1–2 weeks Implications of illiquidity on markets In the case of illiquid assets, the problem is that investor interests do not necessarily align with market conditions. While it may be highly rational for an investor to buy or sell a property, too many investors acting in the same manner at the same time can reduce the liquidity of the whole market. In the end, investors behave in a pro-cyclical manner because they take more extreme positions and trade more often when liquidity is high and revise their ideas if liquidity drops. From a long-term perspective – and this is the horizon of most direct real estate investors – this is irrational. Theoretically, there should be a similar number of transactions in each stage of the cycle. But this is clearly not the case. Between the peak in Q1 2007 and Q1 2009, quarterly commercial real estate transactions in the USA fell by 91% in terms of volume, and they increased by 691% by Q3 2014. Illiquidity is often amplified in abnormal market situations. Moreover, not all real estate segments are affected by illiquidity in the same way. Down markets trigger a flightto-quality effect. Most investors will focus on core properties in prime locations of favored cities such as London or New York – if they are still buying real estate assets at all. Negative consequences are not a given Weeks 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 Investment solutions to meet the illiquidity challenge are very different from country to country, but generally adhere to the same simple idea: pool some properties, securitize them and distribute the shares. Then create a market for these shares. This can be a stock exchange or not. In either case, the shares can be traded more or less continuously and the properties are thus effectively more liquid. Sometimes, a market maker is needed to make the market fully liquid. This not only applies to properties but also to mortgages that are backed by properties. The legal structure of such transactions can be very differ - ent depending on the number of owners and
GLOBAL INVESTOR 1.15 — 47 properties. For all these structures, trust is of key importance, which implies a certain degree of transparency when it comes to valuation for instance. Sometimes illiquidity conflicts with certain investment goals. For example, one concept is to reduce liquidity slightly by increasing transaction costs in order to curb speculation. This may help to lock out investors that have a very short time horizon and are prone to selling assets when the first headwinds occur. Limits to liquidity Even if liquidity is enhanced by pooling properties, there is still no guarantee that this will work all the time. Sometimes pooling properties only results in “pseudoliquidity,” which works when markets are rising (see also “Open-end versus closed-end funds”, page 24). In contrast, in times of falling markets, the number of potential sellers surpasses the number of potential buyers. This can also happen for complex real estate-related financial instruments such as residential and commercial mortgage-backed securities (RMBS /CMBS) as investors learned in the aftermath of the financial crisis. Confidence could not be restored on short notice. The risk of moving from a liquid to an illiquid market environment depends on the legal framework, as seen in the case of German openend real estate funds. The announcement of possible regulatory changes to the corresponding legal framework triggered massive redemptions by investors who wanted to retrieve their capital before the new regulation was introduced. In contrast, listed fund structures with a fixed capital base such as in Switzerland are less exposed to such risks. Selling real estate may become easier As long as properties are tied to specific locations, real estate will face liquidity issues. But we believe that real estate properties will become a priority for investors in the coming decades. First, real estate still does not have the appropriate or optimal weight in many asset allocations. Second, interest rates may stay at low levels for an extended period of time, which makes real estate returns attractive and should help to improve liquidity from the seller’s perspective. Beat Schwab Head Real Estate Investment Management Switzerland +41 44 333 92 42 beat.schwab@credit-suisse.com Swiss real estate funds: Liquidity and diversification Real estate funds are an interesting alternative to investing into physical real estate as they typically offer investors access to diversified real estate portfolios that are managed by experienced real estate professionals. However, the way the product structure deals with in- and outflows of investor liquidity can impact the funds’ returns. Generally, one can distinguish between open-end and closed-end funds. As described in the article by Giles Keating and Lars Kalbreier (see page 24 for more details), these two contrasting structures have both advantages and disadvantages in times of market stress. Swiss real estate funds aim to create a structure that captures advantages from both types, while limiting the disadvantages by having a semi-open-ended structure. This means that funds are opened up to investors during periods of capital-raising activity, but that shares of the funds are otherwise exchanged between investors on secondary markets (with the majority of funds being listed on the SIX Swiss Exchange). Whenever there is strong investor appetite for real estate funds, any excess demand on the secondary market leads to an increase in unit prices and vice versa. However, this excess liquidity does not flow directly into the product and, as such, can neither impact the underlying portfolio nor potentially affect operations, as it is fully absorbed by supply and demand on the secondary market. Typically, this often leads to fund units either trading above (agio) or below (disagio) par to the net asset value of the underlying real estate portfolios. If true investment opportunities arise in target markets, the funds can be reopened for subscription of fresh capital for newly issued units, which can then be put to work. This structure thus enables controlled and healthy organic growth, while also providing a certain degree of liquidity to investors. We also advise real estate investors to diversify internationally. Since real estate market cycles tend to vary between different countries, adding international real estate to a domestic portfolio can significantly enhance the risk-return profile of a real estate portfolio. There are several Swiss real estate funds with an international focus. While such products are denominated in Swiss francs and foreign currencies are mainly hedged, we believe the approach of globally diversified real estate portfolios offers value to investors beyond Switzerland. Philippe Kaufmann Head of Global Real Estate Research +41 44 334 32 89 philippe.kaufmann.2@credit-suisse.com
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