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25.4.2023
On April 4, 2023, the European Central Bank outlined its concerns regarding the role of real estate investment funds (REIFs) in the eurozone. In particular, the growing influence of open-ended real estate funds on the commercial real estate market in the European Union is seen as a risk. The ECB describes a potential threat to the real estate market and the European financial system as a whole.
How should the ECB's statements be classified, how can potential risks be avoided and new opportunities on the real estate market be exploited?
Real estate funds have enjoyed increasing popularity over the past decade. In order to understand the ECB's concerns, we must first look at the type of real estate funds to which the ECB's statements relate. They primarily concern open-ended real estate funds, as investors here have the opportunity to withdraw capital from illiquid investments at short notice, which would increase the pressure on the funds and consequently also on the real estate market.
Both open-ended and closed-end real estate funds offer their investors the opportunity to invest in a broadly diversified real estate portfolio with a single investment. The funds invest in a large number of real estate investments and thus spread the investment risk. This means that comparatively small amounts can be invested in various properties without having to make a direct investment.
A key difference between the two types of fund is the capital commitment. Closed-end real estate funds have a fixed term. The amount of capital to be invested is defined before the start of the term and the corresponding commitment is obtained from the investors. During the term, the fund invests the capital in accordance with the defined strategy, increases the value of the properties and sells them again at a suitable time. If the fund's sales phase coincides with a poor market phase, most fund managers grant themselves extension options so that they can subsequently sell the properties in better market phases. This is intended to avoid negative effects on the fund's performance. The investors' capital is gradually repaid to them. There are no or only very limited opportunities to redeem your own units early.
Unlike closed-end real estate funds, open-ended funds are characterized by the fact that investors can redeem their units at any time and receive the corresponding unit value back. This liquidity is one of the most important features of open-ended real estate funds, as it is a major advantage for investors, who can withdraw their money more easily and at short notice, for example if living conditions change. It is important to note that deadlines must be met for the redemption of units and that many fund managers reserve the right to delay redemption if the necessary liquidity is lacking.
However, as we all know, there are two sides to the coin. While liquidity promises a great advantage for investors themselves, it is also one of the biggest risks of open-ended real estate funds. If many investors want to withdraw their capital at the same time but there are not enough liquid funds available, this can lead to a liquidity bottleneck. In addition, fluctuations in the real estate market can affect the value of the fund and thus the value of the units, which can encourage panic selling.
In its comments, the ECB explains that real estate investment funds (REIFs) have grown significantly over the past decade and have a considerable influence on various local European real estate markets. At the same time, the future prospects for the aforementioned commercial real estate markets are expected to deteriorate significantly. Figure 1 illustrates the growth of REIFs as well as their share of national commercial real estate markets in EUR billion.
The ECB's statement of deteriorating future prospects refers to the increased interest rate environment and the changed macroeconomic conditions. Possible negative developments on the markets can vary depending on the type of use. While some types of use, such as the retail segment or outdated office properties in peripheral locations, could get into difficulties, there are other types of use that have positive prospects despite a changed environment. Segments such as the logistics sector or residential real estate can be counted among the types of use with positive development opportunities. Niche segments such as data centers also offer potential.
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The significant difference in the future prospects of different types of use indicates that risks can be reduced by choosing the right, forward-looking strategy. Even types of use with positive future prospects are affected by a downturn due to the current market situation. However, this can be seen as an attractive time to enter the market and therefore as an opportunity. Equity-rich investors (e.g. REIFs) can act anti-cyclically and acquire properties at a reduced price in order to subsequently benefit from their development by choosing the right strategy and value creation. The prerequisite for this is the necessary liquidity on the part of the funds.
The ECB is therefore right on this point: open-ended real estate funds are exposed to liquidity risk. Real estate as such is considered an illiquid investment, as its sale is both time-consuming and cost-intensive. When investors increasingly withdraw their capital, which often occurs due to cyclical behavior, especially in turbulent market phases, liquidity bottlenecks arise on the part of the funds. This type of imbalance is caused as follows: At times when many investors want to withdraw their capital, properties must be sold from the fund in order to provide sufficient capital for payout. As poor market phases and increased capital recalls usually coincide, the properties are often sold at a loss, which has a negative impact on the fund's performance. Other investors may then want to sell their units, putting further pressure on the fund's liquidity. This results in a phenomenon similar to a bank run.
No. As emphasized by the ECB, the risk of liquidity bottlenecks relates explicitly to open-ended fund structures. This risk can simply be avoided by investing in closed-end real estate funds. Although the invested capital remains tied up for longer, the closed-end structure offers security against liquidity bottlenecks. The possibility of extending the fund term also creates additional security with regard to an attractive exit date. As this is not a new insight, our real estate team relies exclusively on closed-end fund structures.
In its comments, the ECB warns that existing liquidity bottlenecks could have a negative impact on the European real estate market, especially in markets where the market share of open-ended real estate funds is particularly high. If liquidity bottlenecks were to occur across the board in open-ended real estate funds, this could have an impact on local markets.
However, potential negative influences can be put into perspective by the fact that many fund managers use the option of delaying requested capital withdrawals. It is also to be expected that the effects of liquidity bottlenecks will vary depending on the type of use of the properties. This underlines the relevance of selecting a sustainable fund strategy. The ECB's warnings relate exclusively to the eurozone. At the level of the individual investor, it is advisable to invest in closed-end real estate funds and to diversify one's own real estate portfolio internationally in order to spread the risk. Some international markets, such as Asia, have only a low correlation with the European real estate market. Building up a broadly diversified international portfolio can therefore provide additional investment security.
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25.4.2023
Annchristine New
The ECB warns of a potential threat to the real estate market and the European financial system as a whole. How should the ECB's decision be classified? Can potential risks be avoided and new opportunities on the real estate market be exploited?
On April 4, 2023, the European Central Bank outlined its concerns regarding the role of real estate investment funds (REIFs) in the eurozone. In particular, the growing influence of open-ended real estate funds on the commercial real estate market in the European Union is seen as a risk. The ECB describes a potential threat to the real estate market and the European financial system as a whole.
How should the ECB's statements be classified, how can potential risks be avoided and new opportunities on the real estate market be exploited?
Real estate funds have enjoyed increasing popularity over the past decade. In order to understand the ECB's concerns, we must first look at the type of real estate funds to which the ECB's statements relate. They primarily concern open-ended real estate funds, as investors here have the opportunity to withdraw capital from illiquid investments at short notice, which would increase the pressure on the funds and consequently also on the real estate market.
Both open-ended and closed-end real estate funds offer their investors the opportunity to invest in a broadly diversified real estate portfolio with a single investment. The funds invest in a large number of real estate investments and thus spread the investment risk. This means that comparatively small amounts can be invested in various properties without having to make a direct investment.
A key difference between the two types of fund is the capital commitment. Closed-end real estate funds have a fixed term. The amount of capital to be invested is defined before the start of the term and the corresponding commitment is obtained from the investors. During the term, the fund invests the capital in accordance with the defined strategy, increases the value of the properties and sells them again at a suitable time. If the fund's sales phase coincides with a poor market phase, most fund managers grant themselves extension options so that they can subsequently sell the properties in better market phases. This is intended to avoid negative effects on the fund's performance. The investors' capital is gradually repaid to them. There are no or only very limited opportunities to redeem your own units early.
Unlike closed-end real estate funds, open-ended funds are characterized by the fact that investors can redeem their units at any time and receive the corresponding unit value back. This liquidity is one of the most important features of open-ended real estate funds, as it is a major advantage for investors, who can withdraw their money more easily and at short notice, for example if living conditions change. It is important to note that deadlines must be met for the redemption of units and that many fund managers reserve the right to delay redemption if the necessary liquidity is lacking.
However, as we all know, there are two sides to the coin. While liquidity promises a great advantage for investors themselves, it is also one of the biggest risks of open-ended real estate funds. If many investors want to withdraw their capital at the same time but there are not enough liquid funds available, this can lead to a liquidity bottleneck. In addition, fluctuations in the real estate market can affect the value of the fund and thus the value of the units, which can encourage panic selling.
In its comments, the ECB explains that real estate investment funds (REIFs) have grown significantly over the past decade and have a considerable influence on various local European real estate markets. At the same time, the future prospects for the aforementioned commercial real estate markets are expected to deteriorate significantly. Figure 1 illustrates the growth of REIFs as well as their share of national commercial real estate markets in EUR billion.
The ECB's statement of deteriorating future prospects refers to the increased interest rate environment and the changed macroeconomic conditions. Possible negative developments on the markets can vary depending on the type of use. While some types of use, such as the retail segment or outdated office properties in peripheral locations, could get into difficulties, there are other types of use that have positive prospects despite a changed environment. Segments such as the logistics sector or residential real estate can be counted among the types of use with positive development opportunities. Niche segments such as data centers also offer potential.
The significant difference in the future prospects of different types of use indicates that risks can be reduced by choosing the right, forward-looking strategy. Even types of use with positive future prospects are affected by a downturn due to the current market situation. However, this can be seen as an attractive time to enter the market and therefore as an opportunity. Equity-rich investors (e.g. REIFs) can act anti-cyclically and acquire properties at a reduced price in order to subsequently benefit from their development by choosing the right strategy and value creation. The prerequisite for this is the necessary liquidity on the part of the funds.
The ECB is therefore right on this point: open-ended real estate funds are exposed to liquidity risk. Real estate as such is considered an illiquid investment, as its sale is both time-consuming and cost-intensive. When investors increasingly withdraw their capital, which often occurs due to cyclical behavior, especially in turbulent market phases, liquidity bottlenecks arise on the part of the funds. This type of imbalance is caused as follows: At times when many investors want to withdraw their capital, properties must be sold from the fund in order to provide sufficient capital for payout. As poor market phases and increased capital recalls usually coincide, the properties are often sold at a loss, which has a negative impact on the fund's performance. Other investors may then want to sell their units, putting further pressure on the fund's liquidity. This results in a phenomenon similar to a bank run.
No. As emphasized by the ECB, the risk of liquidity bottlenecks relates explicitly to open-ended fund structures. This risk can simply be avoided by investing in closed-end real estate funds. Although the invested capital remains tied up for longer, the closed-end structure offers security against liquidity bottlenecks. The possibility of extending the fund term also creates additional security with regard to an attractive exit date. As this is not a new insight, our real estate team relies exclusively on closed-end fund structures.
In its comments, the ECB warns that existing liquidity bottlenecks could have a negative impact on the European real estate market, especially in markets where the market share of open-ended real estate funds is particularly high. If liquidity bottlenecks were to occur across the board in open-ended real estate funds, this could have an impact on local markets.
However, potential negative influences can be put into perspective by the fact that many fund managers use the option of delaying requested capital withdrawals. It is also to be expected that the effects of liquidity bottlenecks will vary depending on the type of use of the properties. This underlines the relevance of selecting a sustainable fund strategy. The ECB's warnings relate exclusively to the eurozone. At the level of the individual investor, it is advisable to invest in closed-end real estate funds and to diversify one's own real estate portfolio internationally in order to spread the risk. Some international markets, such as Asia, have only a low correlation with the European real estate market. Building up a broadly diversified international portfolio can therefore provide additional investment security.
About the author
Annchristine New
During her studies, she completed a Bachelor's degree in Finance and Accounting at the JGU in Mainz and a Master's degree in Real Estate Management at the University of Leipzig. During her studies, she gained experience in institutional real estate transactions as a working student in the Investment Office of BNP Paribas Real Estate. Her focus there was on data preparation, analysis and valuation of transaction properties.
Ms. Neu is a member of gif (Gesellschaft für Immobilienwirtschaftliche Forschung e.V.), which has set itself the goal of creating professionalized, higher industry standards.
