INREV, the European Association for Investors in Non-listed Real Estate Vehicles, plans to overhaul the way in which fund managers classify vehicles by style. The association wants to use risk as a primary criterion, instead of returns. In 2004, INREV produced its first style classification system, which used target leverage and target internal rate of return (IRR) as criteria.
But as property returns have fallen and fund managers have been forced to lower their return expectations, INREV has reconsidered its position, noting that defining a fund by its returns might no longer be possible.
INREV members have received a white paper proposing a new style classification framework based on the evaluation of six risk factors: leverage, development exposure, income distributions as percentage of total return, country exposure, sector exposure and diversification. The feedback that INREV receives from members will be used to determine which risk factors should be included and which should not, says Andrea Carpenter, director of research and market information at INREV.
Complicated calculations
Classifying vehicles based on various risk factors may involve complicated calculations, starting with the question of how much weight to give to each risk factor. Although the white paper does not address weighing the risk factors, it does explain the risk factors in more detail.
For example, the paper says that development exposure is measured by the expected maximum annual development expenditure as a percentage of overall fund target gross asset value.
INREV has engaged the Cass Business School to identify and evaluate the risk factors. In its report the school suggests that managers should decide how much development risks can be subdivided by type of development exposure.
INREV hopes the industry will comment on all of the proposed risk factors. For country exposure, INREV proposes that risk grading for the target composition of the fund be created by disclosing individual countries targeted by a fund. How the risk of each country would be graded remains unclear. INREV will also decide whether a manager’s classification of their fund’s style fits with INREV’s classification.
“We may go back to a fund manager who says that their fund is core, and say that it actually acts more like a value-added fund,” says Carpenter. “They may still be marketing the fund to their investors as core, which is fine, but for our benchmarking we may choose to define it as value-added.”
Carpenter said that it is important that fund managers continue to self-classify their funds and hopes they will use the framework as a guide.
As part of the proposals, managers of new funds will declare their fund’s style to INREV while taking into consideration the risk factors. They will thus provide additional information and provide the database with a fuller set of style factors.
INREV will then carry out a full review of the existing funds, and look particularly at the consistency between the declared styles and the proposed styles factors in order to establish the typical characteristics of each style category.
The emerging characteristics will be used to check the proposed model and will then be applied to newly launched funds.
“We expect to have this framework up and running in two years, depending on how quickly we can gather the data and do the analysis,” Carpenter says.
