Keeping up the pace
What do you see as the main challenges facing institutional investors?
There is still a considerable amount of capital in the marketplace. The consensus among PREA members is that this trend will continue for some time. Sustained economic growth and low interest rates are among the factors that will continue to encourage the flow of capital into real estate, keeping yields on core property investments low. In response, institutional investors are expected to continue the process of broadening their portfolio compositions and moving out on the risk-return spectrum in search of higher returns. In addition to looking to both international property investments and the leveraging of core property returns via debt financing to enhance returns, investors will further explore non-traditional real estate plays such as inner-city investment, urban revitalisation or so-called emerging domestic markets (EDMs), student and seniors housing, self storage, private equity in real estate companies and joint ventures, as well as infrastructure.
The growth and development of the collateralised debt obligation (CDO) market will continue to change commercial real estate debt finance players, pricing and structures, and further integrate private real estate markets into the wider capital markets. Also, 2007 should mark the beginning of what could be a large commercial real estate derivatives market in the US, further expanding capital sources for the real estate sector and offering investors innovative new ways to gain exposure to real estate and manage risk. At this point in time, return swap contracts are set to start trading over the counter on NCREIF indices as well as on the Chicago Mercantile Exchange (CME).
What are the key challenges facing US institutional investors in real estate and what is being done to address them
First, I would consider real estate pricing. Our members are wondering how long private real estate will be able to generate out sized double-digit returns. Their concern also extends to public real estate securities. Members are questioning whether US REITs' outperformance of the broader stock market and returns in excess of 30% will persist. They are asking if there will be a reversion to the mean and what the implications might be for the flow of capital into and out of the sector. Recognising that readjustments in pricing affect real estate equity as well as debt, they are also concerned about the implications of a real estate downturn for the CDO and CMBS markets. Improved information disclosure and enhanced methods of quantifying and managing risk, both domestically and internationally, will be critical in helping all investors, not just those based in the US, to make better underwriting decisions and to better manage their existing real estate portfolios.
Second, I believe that the rapid pace of today's transactions, in which investment decisions must be made in a matter of hours or days and with limited contingencies, presents challenges for many institutional investors - especially pension funds - which are more accustomed to approving investments at regularly scheduled monthly meetings. In order to compete against private equity funds, REITs and private developers/investors in today's fast moving investment market, institutions will need to rethink their own decision-making processes and likely cede more discretion to their investment advisers.
The growing complexity of real estate investment has led investors to seek more information from objective sources. Associations like PREA can help to bridge the information gap by providing investors with objective, independent research and information. Also, PREA strives to be at the forefront of efforts at enhancing transparency. A good example is our involvement in the founding of the new Real Estate Information Standards (REIS) Board, whose goal is to promote universal standards of performance and measurement in the real estate investment industry.
How much room for improvement is there in the alignment of interests between US
pension funds investing in real estate and their investment manager service providers?
The alignment between pension funds and their investment advisers has improved over the last several years, but there is still room for improvement. These groups have become further aligned through co-investment and incentive fees. For example, many managers are now using meaningful co-investment at the adviser's corporate level, but there is some question about whether such high-level alignment provides a direct incentive to the professionals actually responsible for making investments and managing assets. It is already common to tie employee compensation to investment adviser profitability. Directly tying client performance as a consideration in compensation decisions will help to link more closely investment-adviser decision makers to the objectives of their clients.
The second part is incentive fees. One way to help build a shared vision of real estate investing is to create a fee structure that puts a substantial part of the manager's profit at risk based on client performance. We've already seen this for some time at the opportunistic end of the spectrum, whereas incentive fees have only recently started to appear among US commingled core funds and separate account programmes.
What lessons could European institutional investors learn from US institutional
investors and vice versa?
European institutional investors often have a broader view of the investment universe and are typically weighted more heavily in global real estate, whereas US investors are often solely or primarily focused on US real estate. Although the US is the largest and most liquid real estate market globally, with assets that are as large as the next four markets combined, it still represents only about one-third of the investible global real estate market. European investors are generally more comfortable with cross-border transactions, given their geography, language skills and familiarity with neighbouring cultures. Additionally, European investors tend to hold a larger portion of their total portfolio in real estate assets. We see many US funds becoming increasingly globally-minded (often via exposure to global opportunity funds) but we see this as just the beginning of more fluid capital flows globally for real estate.
European investors can observe how the US markets are moving at an increased pace and how the size and complexity of transactions are also growing, especially in the traditional property types. US pension funds are keeping pace with this trend by expanding their portfolios to include allocations to less traditional or niche property sectors, such as hotels, self storage, healthcare, and student housing, and by delegating more decision-making responsibility to their advisers. They are doing this by making allocations into diversified, commingled funds or by allowing more discretion for their separate account advisers. This level of flexibility and speed helps keep those clients at the forefront of investment opportunities. As this trend of larger, more complex transactions spreads internationally, all investors would be wise to examine and assess their ability to react quickly and decisively.
What do you think will be the chief concerns of the PREA membership at your upcoming Spring Conference?
One of the major areas of focus at the conference will be the consolidation boom in the US REIT market. We will try to understand both the forces driving this phenomenon domestically, as well as how the US public REIT model is emerging globally. Many of our investor members hold public REITs or are considering an allocation to public real estate securities. They will want to get a sense of why consolidation is occurring and what it might mean for their current and prospective investments. Of particular concern are the low cost and prevalence of private equity and debt capital. One important question, for example, is whether the private equity boom represents a permanent shift or a cyclical phenomenon related to public-private market arbitrage.