Author: Joseph Ori, Managing Director, Paramount Capital Corporation
Many pension funds and other institutional investors allocate commercial real estate (CRE) investment funds in to the three property risk classifications of core, value-added and opportunistic and then in to various markets and property types. Allocation into these risk classifications is necessary; however, it should be the second step in a more comprehensive allocation investment strategy. A comprehensive investment allocation strategy should begin with the four quadrant approach to real estate investment. The four quadrant approach for CRE investment strategy was written by me in the Summer 1995 issue of Real Estate Review magazine as well as others from Heitman Properties, Ltd and Property, Portfolio and Research during that time. The approach first allocates the total investable capital to CRE between the public and private real estate markets and then into debt and equity investments within each of these markets. The public CRE equity market is comprised of REITs and real estate operating entities, primarily hotel companies and the private equity market includes all other non-public CRE investment programs including non-traded REITs, private equity funds, closed end funds, commingled funds and special account funds. The public CRE debt market is comprised of CMBS loans and the private debt market includes all private financing from banks, savings and loans, Wall Street, mortgage bankers and private lenders that issue first mortgage loans, subordinate loans, mezzanine loans, bridge loans and participating loans. A graphic representation of the four quadrant investment program is shown in Table I below:
Table I-Four Quadrant Investment Program
Once funds are allocated to the four quadrants, the next step is to allocate the private equity portion to the three risk classifications of core, value-added and opportunistic, the public equity portion to REITs and the debt portions to public and private categories as desired. Some may question including public REITs in the CRE as opposed to the stock equity investment sector of an institutional fund, as REITs have had a 74% correlation with small cap stocks. However, many practitioners believe that public REITs should be included in the CRE sector because they provide liquidity, transparency, long term returns similar to private real estate equity and when included in the four quadrant program, increase return and lower risk. According to a Summer 2011 article written by E. Todd Briddell, President and CIO and Alan Supple, Portfolio Manager of Urdang Securities Management, including public REITs and private real estate equity in mixed asset portfolios produces an efficient frontier line as shown in Table II below.
Table II-Efficient Sets with REITs and Private Real Estate
Both are Better Than One (1994-2010)
Portfolio theory provides a mechanism to examine the role of asset classes, e.g. private real estate and REITs, within a portfolio. An efficient set shows the best risk/return combinations available from a set of asset classes (i.e. the portfolios with lowest risk for a given target return, or alternatively the highest average return for a given risk budget). Given the limitations of portfolio theory as applied here, the specific results should taken with a grain of salt; the discussion is meant to illustrate general issues concerning REITs and private real estate within a mixed-asset portfolio rather than prescribe specific strategic asset allocations. The graph above shows three efficient sets, representing the best possible portfolios in terms of the return/volatility trade-off under three different scenarios. In all three scenarios, investors can allocate to equities, Treasuries, corporate bonds, and hedge funds. Two of the efficient set curves (the dashed lines in the exhibit) correspond to the cases where either REITs or private real estate are added to the basic asset classes. The third curve corresponds to the case where investment in both REITs and private real estate is allowed. (Source: PREA)
Source: PREA: NAREIT, MIT Center for Real Estate, Thomson Reuters Datastream. Based on portfolios including equities, BBB corporate bonds, Treasuries, hedge funds, along with REITs and/or private real estate. Data from Q2 1994 to Q2 2010. Private real estate and REITs measured with same property type weighting; REITs and private real estate are net of fees. Other asset classes represented by the Russell 3000, B of A Merrill Lynch BBB Corp. Index, B of A Merrill Lynch 7-10 year Treasury Index, and the Dow Jones Credit Suisse Hedge Fund Index.
As show in the graph, including public REITs and private real estate in a mixed asset portfolio moves the efficient frontier line up and to the left which signifies more return at less risk.
The final step in the four quadrant investment program is to diversify by geography, industry and property type. A summary of the steps to a comprehensive four quadrant investment approach for a $100 million CRE allocation with proposed percentage allocations are as follows:
- Determine investment allocation, leverage and return requirements from the fund's investment policy statement
- Allocate funds to achieve investment levels of 50% in private equity, 25% in private debt and 25% in public equity
- Allocate private equity to core (33%), value-added (33%) and opportunistic (34%)
- Diversify private equity investments by property type, geography and industry
- Diversify debt investments by property and loan type
- Select real estate managers for fund allocation
See below for a flow chart of a $100 million CRE four quadrant investment program:
Institutional investors should consider the four quadrant investment allocation strategy as the cornerstone of their CRE investment program. Use of the allocation strategy will lower portfolio risk and increase returns.
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