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Real Estate Equity Inve Real estate has a place in a well-diversified investment portfolio. Along with many advantages, real estate investment vehicles and strategies also carry risks that can be minimized. C ommercial real estate equity is a significant asset class for institutional investors seeking to maximize risk-adjusted returns through well-diversified portfolios. It is also a major source of job and wealth creation in the U.S. economy. At the end of 2011, U.S. defined benefit funds had an average allocation of 6.5% to real estate equity.1 Real estate equity assets managed for U.S. tax-exempt investors (including endowments and foundations) as of the end of 2011 totaled $293.4 billion, a 7.3% increase over the prior year.2 With respect to its impact on the U.S. economy, according to the U.S. Bureau of Labor Statistics (BLS), real estate and construction activity accounted for approximately $2.3 trillion of economic activity or 15% of economic activity in 34 benefits magazine may 2013 2010. BLS further reported that 6.9 million Americans worked in real estate or construction in 2010.3 Given the range of investment vehicles and strategies available, real estate has become an accepted and meaningful asset class for institutional investors. Public, multiemployer and corporate pension funds have become significant owners of office towers, apartment complexes, industrial parks and hotels across the nation. The cachet of owning marquis properties is not, however, the appeal. Based on their potential for appreciation and income, low volatility relative to stocks and diversification benefits, real estate investments provide the opportunity to improve expected risk-adjusted returns. Potential benefits of owning real estate through commingled funds, limited partnerships, direct investments or real estate investment trusts (REITs) include: sting for Benefit Funds by | Julian M. Regan • Projected cash yields from rental and lease payments that may significantly exceed yields on traditional investments, especially in a low-interest-rate environment • Total expected returns from two sources: potential price appreciation and cash yields • Lower projected volatility than equities when investing through private vehicles • A potential strategy for protecting assets from the impacts of high and rising inflation • The potential collateral benefit of contributing to economic growth and jobs. Like every asset class, real estate investments expose investors to risks. These include: • Market risks that may be exacerbated by real estate’s sensitivity to economic conditions • Lower liquidity, especially for closed-end, limited partnership and direct investments • Operational and credit risks that are higher than those of traditional investments. Real estate investors have the ability to minimize these risks through an oversight framework that includes documentation of managers’ responsibilities and reporting requirements, due diligence processes to assess managers’ guidelines relative to board risk tolerances, and reporting that provides transparency into diversification, leverage, occupancy rates and sources of returns. Definitions: Distinguishing Between Real Estate Equity and Debt Real estate investing can take two broad forms—equity may 2013 benefits magazine 35 investments FIGURE 1 Real Estate Compared to S&P and Ten-Year Treasury Note 10% 8% 5.42% 6% 4% 2% 0% 2.20% S&P 1.76% Ten-Year Note Real Estate Source: Bloomberg, NCREIF, data as of December 31, 2012. S&P is S&P 500 12-month trailing dividend yield; Ten-Year Note is ten-year U.S. Treasury yield to maturity; Real Estate is NCREIF ODCE one-year income return. investing and debt investing. In the case of real estate equity, the investor typically pools its interests with other like investors to acquire, develop and operate portfolios of office, retail, apartment, industrial and hotel properties. Returns are generated from operating income from rents and price appreciation. In the case of real estate debt, there are two primary methods of investment: direct lending to other entities that are acquiring or developing real estate (originating loans) and investing in debt securities backed by real estate assets. While this article will focus on real estate equity investing, real estate debt also provides benefit funds with opportunities to further diversify their portfolios. Real Estate’s Place Within a Diversified Asset Allocation Structure With the possible exception of daily traded real estate investment trusts 36 benefits magazine may 2013 (REITS), real estate investments are considered to be alternative investments. Like many other alternatives, real estate offers attractive correlation, diversification and risk/return benefits. Private core real estate, for example, offers annualized expected returns that are higher than bonds, but lower than stocks. Moreover, returns from real estate are expected to be less volatile than equities, although they generally have lower liquidity, less frequent valuations and, in some cases, more complex legal structures. Potential Benefits of Real Estate Investing Real estate equity investing offers a number of benefits to institutional investors. These include the potential for cash yields that exceed those of fixed income investments, a total return that benefits from two underlying drivers, lower projected volatility than equities, diversification and a potential hedge against inflation. Cash Yields British philosopher John Stuart Mill once stated that “landlords grow rich in their sleep.” Benefit fund investors can in effect grow rich in their sleep by acting as landlords who accumulate wealth from rents paid by occupants of office buildings, apartment complexes, malls and industrial parks. As of December 2012, the National Conference of Real Estate Investment Fiduciaries OpenEnd Diversified Core Equity Index (NCREIF ODCE) offered a yield of 5.4%, more than triple the yield on a tenyear U.S. Treasury note (see Figure 1).4 Total Return The fact that real estate portfolios have two sources of return, appreciation and income, provides the benefit of smoothing out the return, particularly when appreciation is negative. This is especially the case in more conservative core portfolios that invest in fully developed properties. Real estate, like many asset classes, incurred substantial losses during and after the financial system crisis of 20082009. Notwithstanding this period of volatility, the NCREIF ODCE and NCREIF National Property Indexes (NPI) generated annualized returns of 6.7% and 8.4%, respectively, for the ten years that ended December 2012. (See Figure 2.) Modest Volatility (Relative to Stocks) In the aftermath of the financial system crisis, investors gained a greater appreciation for the damaging impacts of equity risk. Not surprisingly, they are working as hard as ever to find asset classes with smoother return streams. Private real estate investments offered in commingled fund and limited part- investments FIGURE 2 NCREIF ODCE Quarterly Returns Income Appreciation Rate of Return 10% 5% 0% -5% -10% 4Q12 1Q12 2Q11 3Q10 4Q09 1Q09 2Q08 3Q07 4Q06 1Q06 2Q05 3Q04 4Q03 -20% 1Q03 -15% Note: The National Council of Real Estate Investment Fiduciaries Open-End Diversified Core Equity Index (NCREIF ODCE) is an index of private real estate investments that measures the aggregate results from core open-ended real estate funds. Data as of December 31, 2012. nership structures offer the potential for a less volatile return stream. This is evidenced by the fact that the annualized volatility of the NCREIF ODCE Index (commingled openend fund index) for the 20 years that ended December 31, 2012 was 7.0%, a fraction of the volatility of the Standard and Poor’s Index of large-cap stocks (the S&P 500) during the same period, 18.1%.5 (in nominal terms) during inflation. Returns may be further increased if landlords are able to increase rents at a rate that exceeds increases in operating costs. There is no guarantee that this will be the case in every inflationary environment, especially if the economy stalls, but real estate has had a positive correlation to inflation, which means that it rises along with increases in the inflation rate. Diversification Benefits Economic Impacts In their quest for risk-adjusted returns, investors are seeking investments that have a tendency not to move in tandem with equities. By most accounts, the majority of pension funds have 40‒60% allocated to stocks, the riskiest asset class. Any time a pension fund with high equity risk introduces a less volatile asset class that has low correlations to equities, it will improve diversification. Real estate historically has had a low correlation to equities, as evidenced by the fact that its returns do not move in tandem with stocks. This will improve portfolio diversification, all things being equal. Although it is not an investment consideration, a discussion of real estate investing would not be complete without acknowledging the potential economic impacts. Real estate investments that involve development in particular may increase revenues for union contractors, provide jobs for unionized building trades and lead to increased contributions into multiemployer benefit funds. Inflation Protection Although no two inflationary environments are the same, real estate generally provides investors with a better potential hedge against losses during periods of high and rising inflation than do stocks and bonds. The prices of real assets generally rise Risks of Real Estate Investing Real estate investments expose investors to market, liquidity, operational and credit risks that must be understood in order for investors to formulate a plan for effective management. Market Risk Returns from real estate investments are strongly cormay 2013 benefits magazine 37 investments takeaways >> • U.S. defined benefit funds had an average allocation of 6.5% to real estate equity at the end of 2011. • Real estate investments have the potential for appreciation and income, low volatility relative to stocks, and diversification benefits. • Real estate portfolios have returns from both appreciation and income, providing the benefit of smoothing out the return, particularly when appreciation is negative. • Real estate historically has had a low correlation to equities, which may improve portfolio diversification. • Real estate investments expose investors to market, liquidity, operational and credit risks. • When they involve development, these investments may increase revenues for union contractors, provide jobs for unionized building trades and lead to increased contributions into multiemployer benefit funds. related to economic conditions. The great recession of 2008-2009 was an exceptional period, but also instructive. Beginning in July 2008, the NCREIF ODCE Index incurred six straight quarters of negative returns as write-downs due to excess supply and sagging demand overwhelmed property income. This period also served to illustrate commercial real estate’s tendency to act as a lagging economic indicator. Core real estate managers are expected to minimize the probability and severity of losses due to market risks by diversifying assets across multiple properties (sometimes hundreds), property types, regions and tenants and by limiting the use of leverage. Liquidity Risk Liquidity risk is the risk of loss when an investor does not receive its money when expected. The fact that this risk is higher for private real estate equity investments than for traditional investments should come as no surprise. After all, it is impractical 38 benefits magazine may 2013 to sell an apartment complex, office building or hotel on short notice on favorable terms to raise money to pay benefits. While exchange-listed REITs offer daily liquidity, more common institutional vehicles typically offer quarterly liquidity or they lock up investors’ money during multiple-year investing periods prior to making distributions in later years. Commingled fund managers are tasked with managing liquidity risk by keeping enough cash on hand to pay anticipated redemptions. As real estate investors experienced in 2009 and 2010, many commingled fund managers could not meet redemption requests after the financial crisis, which led to redemption queues. Ironically, the environment for real estate has now improved to the point where some high-quality managers have investment queues. Operational Risk Operational risk is higher for many real estate investments than it is for traditional asset classes due to a lower frequency of valuations, more complex legal structures and the number of parties involved in commercial real estate transactions. Specific operational risks for real estate include potential reporting inaccuracies and potential contractual and litigation issues. Managers are tasked with managing these risks by, among other things, conducting best-practice independent appraisals of properties, agreeing to act as ERISA fiduciaries and/or as a qualified professional asset manager (QPAM) where appropriate, and selecting high-quality service providers to administer and audit their portfolios. Credit Risk Commercial real estate investors are exposed to credit risk to a greater or lesser degree based on tenants’ collective ability to pay rents. If the economy goes south, the ability of commercial real estate tenants to pay rents puts the cash yield of real estate investments at risk. Investment managers are tasked with reducing the likelihood and severity of credit risk losses by making sure their properties are occupied by companies with high credit ratings and tenants whose incomes are derived from diverse sectors of the economy. Investment Vehicles, Strategies and Property Types Institutional investors have the ability to access real estate investment opportunities through an array of vehicles, strategies and property types. Determining the best route for an individual benefit fund will depend on trustees’ risk tolerance and the size of their portfolios. For larger funds, diversifying a real estate portfolio across investments FIGURE 3 Private Real Estate Equity Strategies Opportunistic Includes major redevelopment, development, emerging sectors, distressed sellers, etc. Lower ReturnHigher Value Added Properties needing to be leased and typically require significant repositioning, substantial redevelopment and/or development Core Plus Not quite fully leased properties that typically require repositioning and/or moderate redevelopment. Can also be a core portfolio containing some value-added properties. Core Fully leased, multitenant properties that generate cash flow, allow for stable price appreciation and protect against inflation Lower Higher Risk multiple vehicles, strategies and property types will make sense, while smaller funds may have fewer options and be limited to a single vehicle or strategy that typically falls into the core or lower risk category. Institutional vehicles include REITs, open- and closedend commingled funds, limited partnerships and individual properties. All of them have trade-offs. REITS offer daily liquidity but are also the most volatile, since their pricing is subject to investor sentiment. Open-end commingled funds have an infinite life, offer quarterly liquidity and are a common vehicle for similar investors to pool their interests in lower risk core strategies. Closed-end commingled funds have a finite life and may not make distributions until later years when properties are sold. The same is true of limited partnerships that typically invest clients’ assets over a multiple-year investing period before making distributions halfway through a ten-year life. Any of the established real estate investment vehicles may be viable, provided that they are managed by capable, responsive firms that understand their fiduciary duty to the fund and its members. Private real estate equity strategies include core (the most common), core plus, value-added and opportunistic approaches. Core diversified funds have lower risk due to their limited use of leverage and broad diversification across multiple property types, geographic regions and income-generating assets (most properties in core portfolios are fully leased and generating income). Further out on the risk-and-return continuum, core plus, value-added and opportunistic funds have lower occupancy rates, utilize more leverage and include properties in the development and/or predevelopment stage. Because of their higher risk, these learn more >> Education Advanced Investments Management September 9-12, Philadelphia, Pennsylvania For more information, visit www.ifebp.org/wharton. Investment Basics For more information, visit www.ifebp.org/elearning. From the Bookstore Trustee Handbook: A Guide to Labor-Management Employee Benefit Plans, Seventh Edition Claude L. Kordus. International Foundation. 2012. For more details, visit www.ifebp.org/books.asp?7068. may 2013 benefits magazine 39 investments FIGURE 4 Diversification of NCREIF ODCE Index U.S. Geographical Location Property Type Retail 17.3% Apartment 24.0% Other 2.6% West 37.7% East 34.3% Hotel 2.5% Industrial 15.2% Office 38.3% Midwest 9.6% South 18.4% Source: NCREIF ODCE, data as of September 30, 2012. strategies are expected to generate returns that exceed those of equities. Figure 3 provides an illustration. While all property types (office, multifamily, industrial, retail, etc.) exhibit sensitivity to broad economic factors, each type is more heavily influenced by differing factors. For example, office space is heavily influenced by unemployment, while retail properties are affected more by consumer spending and consumer confidence. Industrial property values may be significantly influenced by the level of business investment as well as by in- ventory levels. Apartment complexes have recently delivered some of the best returns in the industry. Their returns have been driven in part by a key demographic trend: declining homeownership in the wake of the financial system crisis. Figure 4 shows the property type and geographic diversification of the NCREIF ODCE Index as of September 30, 2012. Real Estate Investing and Risk Oversight Institutional investors have a number of tools at their disposal to assess TABLE Key Performance and Risk Measures Key Measures Definition/Explanation DiversificationDiversification across properties, markets, property types, strategies and tenants Occupancy Percentage of property that is leased and generating income Net-of-fee returnsNet-of-fee returns relative to benchmarks (e.g., NCREIF ODCE); a measure of the value of active management Capitalization rate (cap rate) Property’s net operating income divided by its purchase price Life cycleDescribes stages of property development—predevelopment, development, leasing, operating and redevelopment Loan-to-value ratio 40 The percentage of a property’s value that is mortgaged benefits magazine may 2013 whether a future or current real estate investment is within their risk tolerance. These include: • Audits of a fund’s internal controls and financial statements along with independent appraisals of property values • Development of an investment policy that documents acceptable investment strategies and vehicles as well as investment manager reporting and compliance requirements • Investment guidelines that set forth the manager’s thresholds for diversification across properties and regions, credit quality and occupancy • Documentation of risk controls, valuation processes, return objectives and, where applicable, the manager’s role as an ERISA fiduciary in legal agreements. Additional tools for risk oversight include ongoing monitoring that is assisted by comprehensive reporting from the investment consultant and managers. Reports should inform fund fiduciaries of the portfolio’s current state relative to key measures including capitalization rates, property life cycles, leverage, diversification, occupancy rates and, of course, net-of-fee returns. (See the table.) Conclusion Real estate equity investing provides institutional investors with the opportunity to add an uncorrelated source of risk-adjusted returns to a diversified portfolio with lower volatility and low correlations to equities. It also provides the potential for protection from inflation and potential economic benefits. Notwithstanding the benefits, there are trade-offs associated with real estate investing. These include market risk, liquidity, operational and credit risks that can be exacerbated in a contracting economy. Real estate investors, however, have the ability to position themselves for long-term success by minimizing these risks through a risk oversight approach that includes audits and assessments, effective investment policy guidelines, contractual provisions and actionable reporting on key performance and risk measures. Endnotes 1. U.S. Bureau of Economic Analysis; U.S. Bureau of Labor Statistics. 2. Pensions & Investments, October 15, 2012. 3. U.S. Bureau of Labor Statistics. 4. Bloomberg, NCREIF, data as of December 31, 2012. S&P is S&P 500 12-month trailing dividend yield, Ten-Year Note is Ten-Year U.S. Treasury yield to maturity, real estate is NCREIF ODCE preliminary one-year income return. 5. Source: Morningstar, NCREIF. Annualized standard deviation derived from quarterly return data from 1Q 1993 to 4Q 2012. << bio investments Julian M. Regan is vice president and senior consultant for the Marco Consulting Group (MCG). He has over 23 years of experience advising executives and trustees of multiemployer and public benefit funds. Regan previously served as chief executive for an $8 billion retirement board as well as in a series of senior management and regulatory roles. He is a member of MCG’s Fiduciary Services Committee and is a frequent author and speaker for leading labormanagement and public benefit plan organizations. Regan, a former member of HERE Local 26 and past appointee to the IRS Tax-Exempt and Government Entities Committee, received M.B.A. and B.S.B.A. degrees from Suffolk University. may 2013 benefits magazine 41