Publications

- January 1, 2019: Vol. 13, Number 1

Running with it: It may hurt now, but more regulation may boost manager returns in the long run

by Bennett Voyles

The equation between regulation and cost may seem fairly simple: the more forms you need to fill out, the more records you need to keep, the more money you will have to pay out to stay compliant with the law.

Many institutional real estate investment firms openly admit that the additional regulation they have had to adhere to in recent years has hurt profitability. But this has not necessarily put them at a disadvantage when com-pared to other alternative investment managers.

“Regulatory compliance has added a layer of costs — for example the need for a depositary under AIFMD — which will erode returns,” says Eoin Bastible, the London-based managing director, head of business development EMEA for UBS Asset Management, real estate and private markets. “But it is not clear this would make the real estate asset class any less desirable relative to other asset classes, given that other classes face similar regulation.”

The reassurance of red tape
The traditional view of regulation as a necessary evil is, however, being challenged. A group of professionals (made up of asset managers, fintech executives and academics) argue that AIFMD, MiFID and MiFID2, as well as the rest of the regulatory alphabet soup, may actually be good for the industry’s profit-ability in the long term.

For one thing, the additional rules may reassure some investors. Jochen Schenk, CEO of German manager Real I.S., points out how the Alternative Investment Fund Managers Directive (AFMD) has resulted in better legal security and transparency in the products offered to institutional investors.

Philippe Deloffre, head of real estate debt at BNP Paribas Asset Management in Paris, believes that all the new regulations have actually helped his business, as they make him look more like his primary competition, conventional banks. “As a direct lender, I am happy to be perceived as being as regulated as a bank,” he explains.

For another, regulation is not just a big pain. It’s also Big Data. “At the heart of every regulation is the need to keep records, so firms are required to keep phone calls, details about counterparties, and economic information,” says Matt Smith, CEO of SteelEye, a data analytics firm. That’s an opportunity as well as a cost, in Smith’s view. “When you start to look at it in its entirety, when you’ve done that right, you suddenly have huge amounts of know-your-customer information,” he says.

The data in the records that companies are required to keep may also be a golden opportunity for them to better understand their employees. Smith notes that, if it is accessible, such data can give a manager important clues about the working methods of its top sales representatives — or an early warning about activity that could compromise the firm.
Another factor that has changed the regu-latory equation, in Smith’s view, is the plung-ing cost of data storage.

In the past, all this information used to be quite expensive to store and maintain, but the cloud now makes such data both much cheaper to store and easier to retrieve. “This stuff doesn’t have to be expensive,” he insists.

Regulation and innovation
Smith is not alone in his belief that regulation may encourage invention. Recent research suggests that regulation can be an important spur for creative thinking in real estate. A study on the topic conducted by Susanne Hügel, a research fellow at the Real Estate Management Institute of the EBS Universität für Wirtschaft und Recht, evaluated data from a total of 403 industry participants working for 197 companies in the German real estate industry. It found that regulation has been a key driver of innovation for the industry and is even more important than competition.

Why would bureaucracy be the mother of invention? One reason, speculates Schenk, whose firm was a sponsor of EBS’ research, may be that regulation often requires clarification of the different stages of a process, making it easier to see how those parts might be made more efficient.

In this particular case, Schenk adds, the shutdown of offshore tax-advantaged funds has forced managers to look harder to find a unique selling proposition. “In former times, the USP was much more country-driven and tax-driven, and that’s no longer possible,” he explains. Now, he says, asset managers have to find ways to stand out based not on tax advantages but on the performance of the actual underlying properties.

For Alexander Taft, managing director – structured finance, Europe, for Invesco Real Estate, the most important benefit has been to drive a cultural shift in the industry toward tak-ing more fiduciary responsibility. “Clearly, the financial crisis was caused by a lack of trans-parency and a lack of cultural values within many companies,” he says.

Taft argues that the new rules have helped change that atmosphere. “This cultural shift is quite dramatic,” says the Munich-based executive. “It wouldn’t have happened without the regulation and potential liability of individuals and without a lot of training and repetitive communication.”

Not just silver linings

Outside of these silver linings, however, there are still some very dark clouds.

Although digitalisation may be driving down some costs, compliance remains expensive, as Ulrich Höller, CEO of Frankfurt-based GEG German Estate Group, explains. “The regulatory requirements formulated by the legislators mean additional costs for each company concerned. The banks are most affected by this. This additional effort is also noticeable for our business, but remains within manage-able limits.”

Heightened supervision has also turned out to be somewhat regressive, falling hard-est on small and mid-sized firms. “Small companies have to spend a disproportionally high amount of time and money to comply with some of the current rules,” says Andre Schmöller, CEO of Domicil Real Estate Group, a medium-sized investment and service com-pany in Munich.

UBS’ Bastible agrees that the new regu-lations have probably fallen more heavily on smaller managers than on industry giants. Larger institutions were already highly regu-lated, he says, and institutional investors have made their own sets of demands on the major managers too, which sometimes go beyond the regulators’ requirements. “Perhaps this is one of the reasons for the wave of consoli-dation in the real estate investment management market, which we have seen in the last 18 months,” Bastible speculates.

Another consequence may be a new division of labour in the market. BNP’s Deloffre believes that smaller firms are less able to cope with this burden will outsource their compliance work to major firms that are better organised to handle it.

For the survivors, however, the outcome seems likely to be positive.

“In the end, if it makes the system safer, regulation should increase the size of the market and therefore reduce the cost in the long term,” says Emmanuel Lumineau, founder and CEO of BrickVest. “In the short term, it will have an impact on the incumbents, who will try to pass that cost on to their clients.”

Bennett Voyles is a freelance writer based in Berlin, Germany.

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