Since the mid 1990s, many institutional investors in the US have been including what they call ‘opportunistic’ investments or ‘opportunity funds’ in their portfolios. The recent growth rates of this segment of the market have been impressive. In its April 2001 report, Pension Consulting Alliance (PCA) indicates that opportunistic real estate funds total in excess of $70bn (e80bn). Further, the Institutional Real Estate Letter in January 2002 reported that plan sponsors allocated 9% of their real estate allocation for 2001 to opportunistic real estate.
As the interest in opportunistic real estate investment has grown, so has the need for an opportunistic real estate investment benchmark. Many investors are unsure as to how to benchmark these investments. The purpose of this article is to shed light on how these investments should be may be benchmarked.
We should first identify what we mean by ‘opportunistic’ real estate funds. These are funds that typically target real estate investment in the higher risk categories. Their investment structures tend to be modelled after private equity investment vehicles. Many try to capitalise on distressed market conditions and/or involve the use of significant leverage. Most opportunistic funds are structured as limited partnerships or limited liability companies with investment time horizons in the five- to seven-year range. Investment advisers/money managers attempt to align their interest with investors by contributing equity capital to the fund partnership. The fund managers also typically receive a back-ended compensation called ‘carried interest’ which is only earned if investors achieve a minimum return threshold.
In recent years, the Association for Investment Management and Research (AIMR) has attempted to standardise both performance measurement methods and performance reporting. AIMR requirements for all asset classes include calculation of the total return, including realised and unrealised gains plus income and time-weighted rates of return (TWR). Portfolios must be valued at least quarterly, and periodic returns must be geometrically linked.
Specific AIMR requirements of real estate investments include independent appraisals at least once every three years and the review of real estate valuations at least quarterly.
Opportunistic real estate investments share many of the characteristics of venture and private placements (private equity investments). The additional AIMR standards for private equity reporting by fund managers require cumulative internal rate of return (IRR) since inception of the fund; IRR computed net of fees, expenses, and carried interest and IRR presented in a vintage-year format.
In the PCA report, Gerrardo Lietz recommends the following best practices for opportunistic real estate funds: report TWR quarterly, on both a gross and net basis, through the calculation date; report since inception IRRs, cash only on a quarterly basis; and report since inception IRRs, realised and unrealised results on a quarterly basis.
Different US plan sponsors place greater or lesser emphasis on the use of IRRs versus TWRs as performance measures for opportunistic real estate funds. Many plan sponsors want to see both performance metrics. Most plan sponsors surveyed reported their performance results to their supervisors on a TWR basis. However, several plan sponsors use the private equity approach and focus on the IRR.
We believe the private equity performance measurement approach will help provide the appropriate returns needed to benchmark opportunistic real estate investments. Our discussion of the benchmarking process follows.
Bailey, Richards and Tierney, in a 1998 article in Journal of Corporate Finance, suggest that a valid benchmark for any investment, should be: unambiguous, investable, measurable, appropriate and specified in advance.
In other words, a valid real estate benchmark should represent a clearly defined, passive alternative investment that the investor could hold instead of the one under consideration. In addition, it should be possible to calculate the benchmark’s performance on a frequent basis. Also, the real estate benchmark needs to be known to all interested parties prior to the beginning of the evaluation period.
Tierney and Bailey, in a 1997 article in Journal of Portfolio Management, suggest that the benchmark for an opportunistic investment (or a series of real estate opportunistic investments), should be composed of benchmarks applied to the investments in which the investor would place its funds were it not to undertake the current opportunistic investments. In other words, opportunistic real estate investments should be benchmarked against alternative investments available to the investor.
This type of opportunistic real estate benchmarking should satisfy the properties of a valid benchmark. However, it is important that the alternative investment reflect the same level of systematic risk (market risk) as that of the opportunistic real estate investment being considered. For example, a domestic real estate opportunistic investment might be benchmarked against a high-beta component of the investor’s domestic public real estate equity benchmark.
A significant amount of capital is flowing into opportunistic real estate investments. This has stimulated a need for appropriate performance benchmarking techniques. Real estate opportunity funds share many similar characteristics with private equity funds. Thus, the performance measurement techniques and benchmarking methods used for private equity are equally appropriate for benchmarking the performance of opportunistic real estate funds. Opportunistic real estate investments can be benchmarked against alternative public investments of similar market risk available to the investor.
Will McIntosh is managing director and William Whitaker is vice president, investment research, at AIG Global Real Estate Investment Corp in New York