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INREV / AREF have published their long-awaited consultation on fund pricing for open ended real estate funds. You can find the report here.
The report was discussed at a discussion forum on 12th December 2017 and will be open for consultation until 31st January 2018. We will be responding formally to the consultation, but in the meantime, we set out our initial reaction below.
Whilst we think that this is an important excerise and a crucial area for discussion, we think that there are flaws in the methodology and we have a slight disagreement with the tenor of the conclusion.
As the authors of the report note, both the traditional method used in the UK of a dual-priced bid offer spread and the European model of capitalisation and amortisation have advantages and disadvantages. They have produced a model to stress test the two methodologies in different scenarios, and have concluded that dual-priced bid offer spread is better in delivering returns to investors in some circumstances and that capitalisation and amortisation is better in others. However, the scenarios in which capitalisation and amortisation deliver a better return are ones where it is effectively assumed that the bid offer spread is incorrectly priced, specifically:
a) The subscrption price is set at NAV plus 5% whilst the actual cost of investing is assumed to have risen above 5%;
b) 25% gearing is assumed and is taken into account in the capitalisation and amortisation but not in the bid offer spread model.
Effectively what the model really shows is that capitalisation and amortisation performs better than bid offer spread if bid offer spread is calculated incorrectly, but worse in every other circumstance.
The longer the amortisation period, the closer to bid offer spread the capitalisation and amortisation model becomes. Capitalising without amortising would the be most accurate form of capitalisation model and would come closest to a perfectly calculated bid offer spread.
If bid offer spread is "better", why are we even discussing this? Bid offer spread delivers a more accurate return to investors in a perfect world. The more difficult it is to accurately forecast the cost of acquiring and disposing of investments, the less efficient bid offer spread becomes. This is particulalry the case if the cost of investing is more changeable. The largest component is real estate transaction taxes, so bid offer spread is most challenging where this is most volatile. for example due to investment in different countries with different tax rates or in situations where the rate may vary (for example acquisition of completed buidlings versus development).
The report overall comes out slightly in favour of capitalisation and amortisation, but recognise that a hybrid model may be necessary. We think further work on the model is needed, are overall more in favour of bid offer spread, but also recognise that a hybrid model may be necessary.
3rd January 2018
You can our formal response to the consultation here.