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