Traditionally, it was believed that value-added funds offer investors higher returns than other types of fund strategies. They are often associated with real estate requiring “corrective action” and strategies that can lead to higher occupancy rates or better rents. These can range from management and marketing improvements, stylish renovations to complex legal or planning issues.
Thus, they were considered “management intensive,” and was previously thought to impose restrictions on their size, especially in Europe. Cain International certainly shares this opinion. He recently closed a € 324 million fund, and European investment head Daniel Harris says the size of the fund allows Cain to be “nimble” and offer a “personal touch.”
Likewise, Jason Oram, partner in Europe Capital, says: “We believe that funds below 1 billion euros are better suited to the added value industry and its myriad granular possibilities.”
For other investors, size is no longer the limiting factor. Paul White, Senior Managing Director Hines, says that “there are more funds.” The first European value-added fund, Hines, raised € 721 million in capital in 2017, while the Hines European Value Fund 2 set an even higher target of € 1.25 billion. White says the fundraising continued throughout 2020 to reach € 1 billion and is expected to be “roughly on track” with the original target.
Toby Phelps, managing partner of BentallGreenOak, agrees. “There is no barrier to fundraising, as long as managers have a sound business plan that they can follow through and continue to gain opportunities,” he says. The first BentallGreenOak fund was € 250 million, the second € 650 million, and the last € 1.46 billion.
In October, NREP closed its fourth series of value-added projects, Nordic Strategic Fund IV, worth almost € 2 billion, surpassing the target of € 1.25 billion. This is more than double that of its predecessor, which was worth 900 million euros. CIO Jani Nokkanen says, “It’s a scalable business – scale gives you a competitive edge.”
Should investors welcome or fear the emergence of large funds? Anna Kuman-Sharapova, Main of European Real Estate at investment advisory firm Mercer, says: “We are especially careful to ensure that the series does not grow too quickly.” But, she adds, “Growth can be a good thing – with a successful manager, you expect the fund to get bigger … Given the size of the opportunity, I see no reason why the funds cannot be bigger.”
Explanations for what is behind the trend vary. Hines, NREP, and BentallGreenOak all mention the accelerating pace of opportunity and suggest that there is something like a virtuous circle. Phelps says, “As you get bigger, you have more opportunities to improve tenant relationships, often across multiple locations and segments.”
Hines notes that the mere fact of size gives the manager an inherent competitive advantage. “Once the funds start entering the € 1.5 billion fund, they will begin to access opportunities only available to funds of their size,” White says.
Nokkanen agrees. “Size can give you other benefits as well,” he says. “You need scale to participate in some of the many interesting hybrid urban developments that are particularly popular in the Northern Region and require experience across multiple segments.”
The last point leads to an interesting question: can only those firms with large internal teams handle larger value-added funds?
NREP, Hines and BentallGreenOak definitely think so. “We love to manage everything ourselves and have built a stronger team,” which is especially important in this “surprisingly opaque market,” says Phelps. White says that “the localized Hynes model means we can aggregate the original capacity of the local network.” Hines employs 600 people across Europe, and White believes that over the past 12-14 months, when travel has been limited, this has given a competitive edge over outsourced centralized models. White argues that Hines’ strong “internal toolkit” allows “intense intervention” and “diverse local presence.”
Nokkanen confesses, “I am very biased. Real estate is always a local business, and this is especially important for increasing added value. ” He notes that “we have all our experience” and “we are determined to be the best home for the most talented.” He cautions that those who rely on external partners are “just one of many clients.”
Others disagree. Europe Capital is happy to use local partners. Oram believes that “it is practically impossible to have all the industry and geographic knowledge within a company that is required for a pan-European foundation.”
Kuman-Sharapova says Mercer wants fund managers to work with partners. “They often have a more innovative mindset,” she says, adding that she “prefers a lean platform with targeted areas.”
Kuman-Sharapova also believes that value-added funds can attract investors due to industry bias. Compared to fixed assets, they tend to be less affected by COVID-19 in sectors such as office and retail. “Fortunately, for the larger value-added funds, retail is not the main business,” she says.
White says a possible tourism resurgence will “rebuild this sector” as “luxury is reborn on the main streets in the city center.” Until then, he’s very picky. The Hines European Value Added Fund offers a unique retail opportunity: a “fantastic building re-creation” at the corner of Bond and Oxford Streets in London’s West End, which White says embodies the essence of value-added investing.
A similar picture is observed with offices, which often account for about 40% of diversified fixed assets. For example, less than 10% of BentallGreenOak’s value-added fund is office assets.
White says that Hines is a firm believer in the long-term future of the office, but the dynamics of the relationship between employers and employees has changed. “There will be some degree to which the talent market will determine what proportion of employees come to the office and not the employer,” he says. In general, White expects a fall in demand for office space by 15-20%.
As with retail, the way forward is selectivity and a commitment to quality. Hines sticks to the first-class segment – the top 5% in the market. “We don’t think this type of office will suffer,” White says.
The need for smarter collaboration and mixed-use spaces may well provide opportunities for value-added managers. Oram says Europa believes that “offices will become the opposite opportunity in this cycle.”
Nokkanen says the trend towards greener and more attractive urban spaces means that value-added fund managers should consider mixed projects that may be driven by residential opportunities but should include office and retail space.
Logistics, meanwhile, has been a favored sector among both asset managers and value-added fund managers, as the pandemic lockdown has accelerated the already explosive growth of online commerce and the need for distribution space to support it.
Logistics accounts for 70% of the BentallGreenOak fund. But Phelps warns that “the space is crowded” and “there are a lot of fanatics around right now.” Fortunately, he says, this is mostly a “core space” problem, and more than “80% of what we do is done outside the market.”
Another popular sector at the moment is residential. White says the “mega trend” of higher rents in the past 12 months has become even more favorable. Likewise, Nokkanen points to long-term structural and demographic trends supporting the sector, such as urbanization and an aging population, and adds that growing financial uncertainty is increasing the propensity to rent. Taken together, White says, “apartment buildings are now even more attractive.”
NREP is focused on “providing secure living for young professionals, students and seniors,” says Nokkanen. Its funds include 12 nursing homes, mostly in Sweden, while investments in Finland include new properties to expand Noli Studios’ serviced housing concept.
Residential assets are attractive to value-added funds and institutional investors more broadly because of the high and reliable returns they can generate. Kuman-Sharapova says many of the Mercer customer responsibility research “pushes them towards profitability, which drives them into value creation.” Basic real estate has lower returns and may not match investors’ target returns.
Value-added funds usually have more aggressive profitability targets. Historically, NREP value added profit targets have been above 20%, and even now they are reaching 16-17%. Hines and BentallGreenOak say their target earnings have not been reduced. Cain’s goal is 13-15%, and Europe’s 12-14%. These levels of return are attractive in a low interest rate environment, which may explain why value-added funds were able to grow in size.