Real Estate and Institutional Investment Strategies

1
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?

2
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

3
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

4
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

5
Special Challenges for Real Estate with the
Efficient Frontier Model

• In practice, it is very difficult to measure real
  estates 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

6
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!

7
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?

8
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

9
How Big was the Bubble?
10
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?

11
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

12
Role of Real Estate in An Investment Portfolio

• Regardless of theory, widely agreed today that
  real estate should be a part of every investors
  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

13
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

14
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

15
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

16
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

17
Return and Risk Attributes for Investment Stages
and Strategies
Entity Investing
Development
Forward Commitment Development
Lease-up,Re-tenantingor Renovation
Re-capitalization
Core
Risk Attributes
ForwardCommitmenton Development
Core
Re-capitalization
Lease-up
Development
Entity Investing

• Stable Market
• Class A B Properties
• Prime Location
• Objective 8-10 IRR
• 80

• Operating Partner Risk
• Reduced Level of Control
• 40-90 Leverage
• Objective 18 IRR

• Leasing Risk
• JV Structure
• Retain Control
• Objective 10-12 IRR

• Substantial Initial or Near-term Vacancy
• Low Initial Yield
• 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

Renovation

• Major CapitalExpenditures
• Increase Revenues
• Objective 11-13 IRR

18
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

19
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

20
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

21
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 RD vs. distribution
• Flex RD 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