Real estate private equity (PE) fund managers around the world continue to face major challenges stemming largely from ongoing illiquidity within the capital markets, a report said.

This has left few able to secure bank financing and stifled deal flow, according to Global Market Outlook: Trends in real estate private equity, a new report by Ernst & Young.

The report, based on a survey of 300 global real estate funds, found that even in heavily favored emerging markets, like Brazil and India, deployment of capital by private equity funds has slowed down. This is largely because of the Eurozone crisis and the uncertainty it has brought to markets around the world.

The one exception is Russia, where domestic banks continue to fund transactions and new development despite their already high exposure to real estate, providing local investors with the means to execute transactions.

Mark Grinis, Global Real Estate Fund Practice Leader at Ernst & Young said: “The still tough global financing market has had a dampening effect on real estate funds but there have been other challenges too, most notably in the significant structural and cultural changes funds are having to navigate coming out of the recession.”

The challenges outlined in the report include: tougher regulatory requirements imposed on fund managers – such as the Alternative Investment Fund Manager Directive (AIMFD) in Europe and the Dodd-Frank Act in the US — and tighter ‘regulation’ from investors in the form of calls for greater transparency and oversight on their investments.

The real estate fund managers highlighted several key challenges for them to get a new fund to its first close, 52 per cent responded that investors required greater due diligence before committing to the fund. Fifty-four percent of respondents also cited agreement on deal terms and fees as the biggest stumbling block.

According to Grinis, although these challenges have caused short term pain for many fund managers, the outlook for most from this structural change is a much more efficient, transparent and scalable platform from which to build future growth.

“This is a period during which creative investors can thrive,” said Grinis. “Real estate fund managers that can successfully navigate the current changes, including demands from investors for greater transparency and lower fees, and who can devise and offer creative niche solutions for investors moving forward will have a key differentiator in the next phase of market growth.”

Real estate fund managers have already seen this. The report details two clear trends — the emergence in the US market of funds created to take advantage of investment opportunities in the single family residential market, and the growing appeal of senior debt funds. Senior debt funds are particularly showing appeal in markets like China, where banks are more limited by regulation than liquidity, and Europe where there is a need for alternative financing. And, in spite of the challenges, fund managers clearly remain cautiously optimistic.

When asked if their next fund would raise more, the same or less capital than the last, an overwhelming majority (more than 71 per cent) predicted raising about the same or more with less than 29 per cent expecting to raise less than the prior fund.

Operational issues

Operational efficiency and performance improvement is critical for funds moving forward, according to the report. “The back office is no longer back-of-mind,” says Grinis. “In the face of declining fees, increased regulatory costs and investor demands for greater transparency, funds are far more focused today on performance, efficiency and cost control,” he adds. About a third of fund managers surveyed indicated that operating costs have risen by more than 5 per cent as a result of compliance with new regulatory regimes such as AIMFD and the Dodd-Frank Act.

Another 38 per cent have yet to calculate that cost and just under a third estimated that costs have risen less than 5 per cent. In an effort to control costs, more funds are looking to outsource functions like property management, property and fund accounting and fund administration and reporting. Funds are also increasingly looking to lower cost options offshore for some of these outsourced functions.

Sovereign wealth

One potential area of opportunity for fund managers could be the growing global involvement in real estate investing of sovereign wealth funds (SWF). Over half of the respondents to the survey are already working with SWFs. The clear trend among these investors is to opt for separate account or joint venture (JV) relationships with fund managers rather than the typical commingled fund arrangement.

Twenty-two percent of respondents indicated they had separate account or JV relationships compared with just 5 per cent who counted an SWF investor in one of their fund vehicles. Fund managers flexible enough to embrace the separate account structure or JVs, and also accommodate SWFs’ often unique transparency and disclosure requirements, have a definite advantage in attracting SWF capital.

In addition to an overall discussion of the global fund sector, this year’s report includes analysis of the major emerging markets – Brazil, Russia, India and China.  – TradeArabia News Service