Real Estate Funds
ESMA alerts to the leverage risks associated with real estate funds
On 30 January 2024, ESMA conducted a risk analysis and assessment based on AIFMD data and designated risk indicators in order to publish its 2023 EU Alternative Investment Funds Market Report as well as its Risk Analysis of the risks posed by leveraged AIFs in the EU.
Article 25 AIFMD (AIFMs managing leveraged AIFs - use of information by competent authorities, supervisory cooperation and limits to leverage) delineates pivotal measures purposed to fortify financial stability within the AIF sector throughout the EU market. Upon identification of potential risks, NCAs have the prerogative to impose constraints on leverage employed by AIFMs. In this regard, ESMA's guidelines on Article 25 AIFMD furnish a standardised modality for discerning and evaluating AIFs entailing leverage-related perils, thereby expecting NCAs to evaluate systemic risks associated with use of leverage and establish limits.
The financial market landscape and structural changes in real estate markets had a negative impact on real estate investment funds in 2022. Real estate investment funds notably face multiple risks related to leverage, market footprint, valuation discrepancies and liquidity mismatches. Liquidity mismatches therefore remain a key vulnerability for open-ended real estate investment funds, especially for investment funds that offer redemptions at high frequency, with real estate investment funds being the most exposed to liquidity mismatches.
Hence, ESMA has expressed apprehensions regarding the substantial leverage embraced by numerous real estate investment funds. ESMA identifies liquidity incongruities as a principal vulnerability, especially amongst a subset of investment funds harbouring considerable illiquid assets. Remarkably, 89% of the sampled portfolios manifest an incapacity for liquidation within a three-month timeframe, thereby engendering potential contagion risks to financial institutions. Although the average liquidity incongruity in Luxembourg remains restrained, a subset of funds evinces notable disparagements, emblematic of a varied market composition encompassing open-ended and closed-ended real estate funds within the jurisdiction.
In response to these conclusions, ESMA accentuates the imperative of vigilant oversight and risk mitigation within the real estate investment fund sphere. In Luxembourg, real estate investment funds moderate their use of leverage; nevertheless, the leverage mechanism is widely used causing the CSSF to diligently monitor the financial sector.
ESMA unveiling risk exposure of real estate AIFs
On 10 January 2024, ESMA offered a comprehensive analysis of the real estate market dynamics within the EU and the related real estate risk exposures faced by EU securities markets and investment funds.
ESMA identifies a myriad of factors that contribute to these risks, illuminating the intricate challenges and vulnerabilities inherent in the real estate market. These factors encompass fluctuations in property values, liquidity constraints, and the cyclical nature of economic conditions impacting real estate investments. The illiquid nature of these investments, coupled with the difficulty in accurately valuing assets during stress periods such as the COVID-19 pandemic and more recently the Ukrainian war, renders them vulnerable depending on the liquidity terms offered to investors.
Moreover, ESMA underscores the paramount importance of vigilant monitoring and effective management of these risks, particularly for investment funds heavily exposed to real estate assets. This includes addressing liquidity mismatches between fund investments and redemption regulations, the overreliance on leverage, and interconnectivity. ESMA emphasises the necessity for robust risk and regulatory management frameworks and strategies to mitigate potential drawbacks and safeguard investor interests.
For real estate investment funds specifically, this entails closer alignment between fund redemption terms and investment strategies. ESMA further recommends the adoption of anti-dilution liquidity management tools (LMTs) for less liquid assets, alongside enhanced preparedness for cash requirements arising from margin and/or collateral calls in derivative and repurchase agreements transactions