Real Estate and Institutional Investment Strategies
Lecture Map– Institutional Portfolio Management– Role of Real Estate in an Investment Portfolio– Asset selection within the Real Estate Asset
Class What do institutions want from their real estate
investments? Is there a ‘best way’ to select real estate investments?
Portfolio Management Theories
Efficient Frontier Theory– Optimize combination of assets along the “efficient frontier”
to maximize returns relative to acceptable level of risk– Diversify portfolio to reduce correlation of returns, thereby
reducing risk as much as possible given targeted return
Immunization Strategies– Select base portfolio to cover projected stream of liabilities– Balance of the portfolio invested to enhance returns
The Efficient Frontier
In theory, investors should maximize returns at the margin for the amount of risk they are willing to bear
“Risk” in this case is measured by the volatility of returns and the correlation - or lack thereof - of relative returns across asset classes
Assets are worth more in combination than individually if optimally combined based on the covariance of their returns
Constructing an Efficient Portfolio
Choose the asset mix of your portfolio– Growth stocks– Value stocks– Fixed Income– Real Estate
Direct Commingled Funds REITs
Change the asset mix change over time– Market Timing– Style Rotation– Change in target risk and return
Special Challenges for Real Estate with the Efficient Frontier Model
In practice, it is very difficult to measure real estate’s correlation with other assets
– Historical data is not as robust as it is for stocks, bonds, making measurement difficult
– Private real estate markets are also fragmented, inefficient, illiquid
Some properties correlate well with bonds – single credit net lease deals, multi-family
Others exhibit high volatility – hotels, suburban office Performance can vary significantly between properties,
markets
Other Challenges of the Model
The efficient frontier ignores pension liabilities– Assets are selected based on what they contribute to the total return
goals of the portfolio– Plan sponsors would also like to generate income that matches their
liabilities– Liabilities are gaining focus today because of the losses of recent
years
Benchmarking against target returns and indexes is also problematic for real estate
– Most targets are annual– Most indexes are benchmarked quarterly– Real estate is a long term asset!
Portfolio Immunization
Investment strategy based on meeting planned and/or projected liabilities versus a target rate of return
Methodology splits the portfolio into two pieces:– Core investments indexed to liability streams
Generates income to match size, timing of liabilities Ties well with fixed income investments
– Balance of the portfolio invested to enhance total return Alternative assets, equities, etc.
Works best with fully and/or overfunded pension plans– Underfunded plans are by definition behind the total return curve in
meeting even known liabilities Lots of plans are underfunded today, however → should they take
more risk to meet obligations?
Portfolio Immunization (cont.)
Immunization is getting lots of attention in the portfolio management world today:– “Post bubble” phenomenon
Institutional portfolios severely hurt by tech boom/bust Portfolio discipline was missing in over-allocation to
tech, private equity and venture capital Concern over looming obligations to retiring baby
boomers
How Big was the Bubble?
DJIA S&P 500 Nasdaq
Aug 29, 2003 Price 9,416 1,008 1,810Peak Price 11,723 1,527 5,048Date of Peak 1/14/2000 3/24/2000 3/10/2000
Years to Peak Prospective Returns (%)
1 year 24.5 51.5 178.9
2 years 11.6 23.1 67 5 years 4.5 8.7 22.8 10 years 2.2 4.2 10.8
15 years 1.5 2.8 7.1
20 years 1.1 2.1 5.3
25 years 0.9 1.7 4.2
Returns Needed to Get Back to the Peak
DJIA S&P 500 Nasdaq
Aug 29, 2003 Price 9,416 1,008 1,810Peak Price 11,723 1,527 5,048Date of Peak 1/14/2000 3/24/2000 3/10/2000
Years to Peak Prospective Returns (%)
1 year 24.5 51.5 178.9
2 years 11.6 23.1 67 5 years 4.5 8.7 22.8 10 years 2.2 4.2 10.8
15 years 1.5 2.8 7.1
20 years 1.1 2.1 5.3
25 years 0.9 1.7 4.2
Other Attractions of Immunization
Stop the proliferation of ‘asset classes’– Immunization would classify assets by their role in the
portfolio as opposed to role in diversification “what is the job” of each asset? Inflation hedge; current income; long term growth
How efficient is asset allocation today anyway?– Look at real estate fundamentals vs. pricing– Are we creating another bubble of a different type?
Why Real Estate Looks So Good in the Immunization World
Real estate combines return features of both bonds and stocks with low correlations to those asset classes
– Current income and total return – Same argument used by the efficient frontier model, but for
immunizers, the current income provides a hedge against liabilities; growth component offers “alpha”
Real estate also offers multiple investment strategies within the asset class to enhance total return
– Opportunistic plays– Property type and sector plays– Market selection
Role of Real Estate in An Investment Portfolio
Regardless of theory, widely agreed today that real estate should be a part of every investor’s portfolio
Real estate offers an ideal fit – Efficient Frontier → low correlation
→ diversification → fixed income and
appreciation attributes– Immunization → fixed income attributes
→ return enhancement
opportunities Also generally agreed that investors are on average
significantly underweighted in real estate
Institutional Real Estate Strategies
Involves Selection of Investment Vehicles and Managers
Primary Investment Vehicles:– Private Equity Real Estate Funds
Core Value-Add Opportunistic
– REITs Market proxies Regional, property type plays
– Direct Deals
Institutional Real Estate Strategies (cont.)
Implementation of any strategy is critically dependent upon manager selection– Expertise and track record
Deal experience History of producing targeted returns
– Transparency How good, frequent, honest is the reporting?
– Alignment of Interests Incentive-based reward structure
Institutional Real Estate Strategies (cont.)
Institutions invest disproportionately in private, direct deals today– Public REIT markets, universe of private equity
funds too small to accommodate available capital– Selection of, relationship with manager is key
Real and/or perceived ability to influence operations and outcome of the investment
– Facilitates periodic rebalancing if needed Less liquidity than a REIT, but more than a fund with a
greater degree of control over the asset, exit timing
Real Estate Investment Strategies – Moving Beyond the Vehicle
Real Estate provides multiple opportunities to enhance returns at the margin in all investment vehicles
– Stage and/or strategy selection– Property type allocation– Regional allocation – Market Selection– Property Selection
What are the selection issues?– Correlation between strategies– Long term economic and demographic shifts
Return and Risk Attributes for Investment Stages and Strategies
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Core
Re-capitalization
Lease-up,Re-tenantingor Renovation
ForwardCommitmentDevelopment
Core Re-capitalization
Renovation
Lease-up
ForwardCommitmenton Development Development
• Stable Market• Class A & B Properties• Prime Location• Objective: 8-10% IRR
• 80% +
• Leasing Risk• JV Structure• Retain Control• Objective:
10-12% IRR
• Substantial Initial or Near-term Vacancy
• Low Initial Yield• Objective: 11-13% IRR
• Major CapitalExpenditures
• Increase Revenues• Objective: 11-13% IRR
• Minimal Construction Risk
• Minimal Zoning/Entitlement Risk
• Fund at Completion• Leasing Risk• JV or Wholly-Owned• Objective: 12-14% IRR
• Limited Construction Risk• Leasing Risk• Minimal Zoning and
Entitlement Risk • Objective: 13-18% IRR
Development
EntityInvesting
Entity Investing• Operating Partner Risk• Reduced Level of Control• 40-90% Leverage• Objective: 18% + IRR
Risk Attributes
Value-Added Strategies
Property Type Allocation
Office and Industrial properties are most cyclical, most closely reflect economic cycles
– Office → either the best or the worst performer. A lagging indicator. Time the cycles, underweight suburban “commodity” deals in general
– Industrial → generally outperforms office, more stable returns than office. More of a leading indicator.
Retail and Multifamily are considered more stable– Retail → negative correlation with office, good absolute
returns. Reflects consumer-driven economy– Multifamily → considered defensive, counter-cyclical.
Influenced by demographic trends as well as job growth
Regional Allocation
Property type selection within regions is important– Gets back to economic base analysis!– What industries, activities drive the local economy and will be reflected in
real estate needs? East and West
– Higher returns, higher risk– More heavily concentrated in office product because of the financial focus
of coastal economies Midwest
– Correlated with the East coast, although more heavily industrial in nature South
– Low correlations with West, higher risk adjusted returns on average than either coast
– Long term demographic shifts favor the south
Market Selection
Drivers of Market Selection:– Employment growth and comparative economic strength– Ease of adding new supply– Historical absorption track record– Property preferences → which do better in given market?
International vs. National Markets:– Direct comparisons are difficult to make
U.S. market is a “traded” market; foreign markets are not Long term holds might favor stability of yield in W. Europe
– Does the recommended diversification model apply here?– Prologis strategy: provide U.S.-style service to customers in foreign
markets– Goldman approach: move opportunistically in and out of international
markets
Property Selection
Pick your size– Smaller assets have historically outperformed larger assets
Wider audience offers greater liquidity If your holding period is short, evaluated exit opportunity
Pick within asset classes– Suburban vs. CBD office
CBD considered more stable– Regional mall vs. power center vs. neighborhood center
Neighborhood center in favor– Flex R&D vs. distribution
Flex R&D is more cyclical– Garden-style multifamily vs. high rise, urban condominium
Garden-style considered more generic and defensive– Full service, limited service, resort hotels
Luxury full service most defensive, resort most cyclical