Has it ever been better than it is now to be involved in institutional real estate investing? Everyone is happy and everyone is making money. We have advised institutions regarding their real estate programmes for more than two decades and we have never witnessed a period like the one that exists today. Capital has and continues to flow into the asset class. Why?
There are some well-known causes for the capital inflows. First, a correction in the equities market in 2000 educated the investment community as to the risk in that sector and let them know that a period of unprecedented run-up in the stock market had come to an end. Second, interest rates went to historical lows. Third, the best consultants advised institutional investors that traditional asset class returns would be lower and that the institutions should look to alternatives as a means to add alpha. Fourth, demographics created a demand for an investment sector that was perceived to have less risk, that provided a relatively attractive current yield, and that was expected to hedge inflation.
It was an ideal introduction for real estate. It was an alternative asset. It had an attractive current yield. It could be easily leveraged. It fitted the demand in the market perfectly.
But that does not really give credit to the asset class of real estate. As an asset class it had greatly improved. The dramatic correction in the real estate market in the late 1980s and early 1990s caused investors to re-evaluate it. This created the opportunity for the best and brightest minds to improve upon it.
What was the result? We had the emergence of the public real estate equity and debt markets; we had new entrants to the market providing investment advice; we had new investment manager models; we had new investment strategies with risk that ranged from bond-like to private equity - like we had an emerging global institutional real estate investment market; we had greater understanding of real estate relative to the other asset classes; and we had greater transparency. These improvements that began during the early 1990s made real estate perfectly positioned to meet the demand of institutional and retail investors for an alternative to the traditional asset classes.
Have the investors been rewarded? By almost every measure the answer is a resounding ‘yes'. Let's look at the numbers. Shown in figure 1 are rolling one-, three- and five-year returns for the NCREIF Property Index (NPI) which measures the property level returns of institutional quality core (relatively low risk) real estate located in the US.
But it is not only the lower-risk investors that have been rewarded. Those willing to assume more risk have been well rewarded too. Set forth in figure 2 are the rolling one-, three- and five-year returns for The Townsend Group Value, High, and International Real Estate Fund Indices. As you can see, everyone is being rewarded for investing in the asset class.
And it is not only the private market investors who have done well. Those investing in public market equity real estate securities have been very pleased. Set forth in figure 3 are the one-, three- and five-year returns for the NAREIT Index.
So the past looks great. But what does the future hold? Based upon supply and demand and upon occupancy and rent growth it appears the party has just begun. Across all property types and across all regions the data looks better today than it ever has during this cycle.
Are there any issues? Unfortunately there are: pricing, discipline and opportunity. The hottest topic of discussion is pricing. A large part of the returns achieved across all strategies has been a function of declining cap rates (the yield required to induce an investor to buy) and leverage. Cap rates are now at historical lows. Figure 4 is the rolling one-year cap rate of properties in the NPI.
There appears to be little opportunity to add to the return through further cap rate compression. The issue has become whether cap rates will increase rather than decline further. And the returns projected by managers across nearly all strategies have declined. For example, each quarter we survey the all US core open-ended commingled funds. At the beginning of 2007 The Townsend Group Core OECF Index equivalent of the average projected return for the properties in those funds was 7.7% which is a historical low. We are observing a similar dynamic across all regions (US, Europe and Asia) and all strategies (core, value and high).
The flow of money to real estate has put pressure on the discipline in underwriting by all participants. Managers are complaining that it is so competitive in certain markets that they are frequently not allowed the time to perform thorough due diligence. And institutional investors are finding themselves squeezed out of funds if they do not quickly commit.
Unfortunately investors cannot rely solely on fund structure to provide discipline and align interests. It is common for fund sizes to exceed a billion dollars or euros, and investment management fees (which were intended only to cover ‘costs') to be 1.5% on committed capital. These funds originally designed to reward managers only if returns were achieved are now profitable to the manager without incentive fees. The flow of money to the sector has put the managers in the driver's seat.
The flow of money to the sector has also reduced the opportunity to achieve outsized returns. The developed markets are in equilibrium. The myriad of strategies based upon providing liquidity to distressed markets no longer exists for the vast majority of regions. Targeting higher returns today means assuming more traditional real estate risk such as leasing and development in developed countries; implementing private equity-like strategies such as LBOs of public companies; and investing in emerging markets.
This is not to suggest that all is gloom and doom. There are rich investment opportunities in the market. And there are highly skilled real estate experts with which to invest. And there is a wealth of information and expertise to assist the investor. But it is a good time to reflect upon lessons learned from past experience. And I would focus my efforts on three key areas.
irst, develop an effective long-term investment strategy to guide the programme through real estate cycles. A consistently successful real estate programme begins with a well thought out and articulated investment strategy. The asset class has matured. An institution can now invest in the public and private markets, domestically and offshore, and in strategies with risk that ranges from bond-like to private equity-like. And it can invest through traditional investment managers or directly with the operators. These top-down choices enable an investor to structure a programme to achieve specific and discrete goals.
The two most important questions to answer are: what is the role of real estate in the broader investment programme, and what is the performance benchmark that defines success. With that direction policies can be developed to define the level of risk required to achieve the benchmark and to effectively manage that risk.
Real estate is a relatively inefficient asset class but today there is quantitative data that can assist an investor to make more informed decisions in the development of its strategy. For example, figure 5 provides an efficient frontier for a real estate programme. It uses data extrapolated from the performance of the private and public real estate sectors. That data was not available a decade ago.
A clear real estate strategy will guide the investor through real estate cycles and minimise the risk that it gets caught in the ‘moment'. It provides a framework within which an investor can tactically execute and capitalise on market dynamics and investment opportunities.
Second, do not invest unless you know and understand the investment's strategy, sponsor and structure. This is easier said than done. As the complexity, risk and return of the investment increases the more important it is to understand the risks that are being taken, the team that is executing, and the structure that determines your rights and your rewards. Above I referenced how well real estate and especially the higher-risk sectors have performed during this recent cycle. Figure 6 provides a distribution of the funds that comprise the returns for the core and high-return sectors for the five-year period.
These graphs illustrate the importance of selecting the best funds. This is especially true for the higher risk and return strategies.
Investors should focus upon the returns that they receive, ie the net return to them. Investment structures have become complex and understanding the effect of fees and costs is increasingly difficult. The table below is a simple illustration. It provides fee structures common to enhanced and high-return funds. It provides the percentages of the return over the expected return for core real estate that is paid to the manager under the respective fee structures for achieving that level of alpha.
he analysis illustrates the effect of fees on the return to the investor. It does not address the more complex costs that need to be understood such as sharing of revenues with the manager's operating partner or the costs of local taxes - which brings me to the final lesson learned from past experience.
Third, use the information resources available to you to gain the competitive advantage. Real estate is an inefficient asset class, and information provides a competitive advantage. A significant premium can be achieved through informed decisions.
The evolution of the asset class during the last 15 years has provided the investor with many top-down choices in the development of its strategy and in the selection of its investments. In a well-diversified programme those top-down choices will drive the programme's intermediate and long-term returns more than any single investment that a manager makes.
Is there a lot to know? The simple answer is yes. There is more to know now than ever before. For example, figure 7 shows funds by sector that are currently available for investment.
There are 398 funds available for investment. The opportunity set is global, it spans the private and public markets, and it encompasses a broad range of strategies. It comes packaged in diverse and complex investment structures. And it is offered by investment managers that increase in number every day. The markets are in equilibrium. Achieving alpha will mean investing in new and emerging strategies. The challenge is how to execute in an informed way.
A rising tide lifts all ships and we have had a rising tide in the real estate sector. There is a wealth of investors that will continue to provide liquidity to the market. Going forward, thoughtful and informed investors will be rewarded. Those simply following the herd may suffer. The real estate market is rich in investment opportunities for those who know where to look.
Fortunately there is also a wealth of information that was never available to investors in the past. There are industry organisations, indices, specialised consultants, and funds of funds that provide access to all investors to the required information and expertise. Those who capitalise on it will be well rewarded.
Terry Ahern is principal and founder of consultancy Townsend Group