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Leaving Their Comfort Zone

Enticed by commercial real estate's healthy returns over the past several years, institutional investors continue to plow increasing sums of capital into an assortment of property markets, but with a new twist: Advisors are recommending that their institutional clients eschew core investments and domestic REITs in favor of value-added, opportunistic and global investments.

Why? Quite simply, pension funds, endowments, foundations and insurance companies are having a hard time finding attractively priced investments with acceptable returns. The capital that is flooding the real estate market is compelling advisors to encourage their institutional clients to re-evaluate the types of real estate in which they are willing to invest.

“It's not about core investing anymore — the higher-risk sectors like value-added, opportunistic and international are clearly growing, particularly with pension funds,” says Peter Schaff, the regional CEO for North America at LaSalle Investment Management. “Investor sentiment is to move up the risk curve to get higher yields.”

This year, institutions plan to sink $12.9 billion into core real estate investments — Class-A properties that are well-stabilized — compared with $19.9 billion in 2005. In percentage terms, their allocation to core real estate is expected to drop from 38.7% in 2005 to 21.8% this year, based on a recent survey conducted by Kingsley & Associates, a real estate research and consulting firm, and Institutional Real Estate Inc., a publishing and consulting house (see chart on opposite page).

Kingsley queried more than 100 institutions that control nearly 44% of all assets held in tax-exempt real estate investments and found that in 2006 they plan to increase their allocation to higher-yielding strategies (value-added and opportunistic) from 53% to 63%. It marks the first time that the lion's share of capital isn't directed at core properties. Together, value-added and opportunistic investments will account for $31.3 billion in 2006.

Foreign investment — which includes both private equity funds with non-domestic properties and non-U.S. publicly traded REITs — is expected to account for more than 10% of institutions' real estate allocations in 2006, according to the Kingsley survey. This is the first time in the survey's history that foreign real estate allocations have reached double digits.

The clear trend line among institutional investors is that real estate has become a much more attractive asset class, evidenced by the rising allocations, says Marc Louargand, managing director and chief investment strategist of Cornerstone Real Estate Advisers. Over the past few years, most institutions have at least doubled their allocations, he says.

Indeed, new capital flowing into real estate from institutions is expected to increase by 15% this year to $59 billion. That's up from $51 billion in 2005 (see chart on page 54). This is the fourth consecutive year in which institutions raised their percentage of real estate allocations by double digits. To put that growth in perspective, the projected volume for 2006 is more than twice that of 2002.

Even though returns have been very healthy, they are falling slowly and inexorably because of the flood of capital chasing real estate deals.

“If you look at the current marketplace today, the decline in cap rates and reduction in returns creates a situation where there is an increasing challenge to match investors' expectations with the reality of the market,” says Ed Pierzak, director of research and co-portfolio manager for Henderson Global Investors. The Chicago-based advisor sponsors commingled funds and manages separate accounts. Indeed, cap rates have dropped from 8% to 5% over the past 24 months for core assets in major markets.

Analysis of allocations

The Kingsley survey shows that institutional investors are listening to their advisors. Most of the institutions are directing money away from U.S. stocks into real estate, although the survey found that U.S. stocks, foreign equities and fixed-incomes account for nearly 60% of the total planned investment for 2006. On average, institutional investors expect real estate will account for 7.9% of their total investment portfolio this year, but some institutions plan to invest as much as 10% to 15% in real estate.

Institutions continue to raise the percentage of their real estate allocations because the sector still offers compelling returns relative to other types of investments. “Even though prices for real estate are continuing to rise, we feel that real estate is offering a fair-return alternative compared to bonds or equity,” says Schaff of LaSalle Investment Management. “Real estate still deserves its place in the portfolio and should be grown somewhat. Institutions in the U.S. concur.”

In 2006, institutions expect a total return of 8.1% for their real estate investments, according to the Kingsley survey. That modest uptick still provides a better risk-adjusted return than other asset classes, according to the survey. Using a metric known as the Sharpe Ratio, which measures the incremental return over the risk-free Treasury yield, real estate offers a return of .35 for every unit of risk compared to .25 for U.S. stocks, .26 for foreign equities, .175 for fixed-income assets, and .3 for private equity.

Why core is out of favor

Not only are institutions bulking up on real estate allocations, they're also making a big change in the way that money is divvied up. Historically, two-thirds to three-quarters of all real estate dollars were committed to equity investments in core properties, with the remainder marked for value-added and opportunistic plays.

“Given the extreme core pricing in today's marketplace, we're finding that there are better risk-adjusted strategies in value-added and opportunistic investments,” says Marc Weiss, a principal with Pension Consulting Alliance.

Advisors expect core U.S. investments will offer a total return of 8.7% in 2006, while value-added and opportunistic investments will provide total returns of 11.5% and 15.2%, respectively. REITs are forecast to offer a total return of 8.5%, according to the Kingsley survey.

“A year ago, value-added people like us were talking 15% to 18% net to the investors,” says Gene Zink, CEO of Triton Real Estate Advisors. “But everything we hear today is 13% to 14%. Clearly, the market is adjusting to the reality.”

Zink believes that core properties today are risky because cap rates are so low and buyers are paying more than replacement cost. The good news is that high construction costs are keeping new development to a minimum, leading to greater market equilibrium.

Investor confidence is driving much of the strategic shift. Many institutions have gained experience in real estate and profited handsomely. Increasingly, they are moving away from core investments and domestic REITs into value-added and opportunistic vehicles as well as foreign REITs and global funds, according to several institutional advisors.

“As the industry has matured, real estate has become a very accepted investment,” notes Richard Price, managing director of ING Clarion Partners. “Institutions have used core investments to get comfortable with real estate as an asset class, and now that they're comfortable they're moving up the risk spectrum.”

Institutions plan to spend $15.5 billion in value-added investments this year — roughly one quarter of their total real estate allocation — up from $10.5 billion in 2005, according to the Kingsley survey. Similarly, institutions expect to plow $15.8 billion into opportunistic equity investments in 2006, up from $12.19 billion in 2005.

Like core investing, value-added and opportunistic equity investments can be made through advisor-sponsored funds, or through a separate account where larger institutional clients build a diversified portfolio on their own without pooling their money into a fund.

In general, institutions increasingly prefer commingled funds to place capital, and almost three-quarters of new allocations will go to pooled funds, according to the survey. In 2003, institutions allocated 36% of their investment dollars to separate accounts compared with 23% this year. Institutions are simply looking for the fastest and easiest way to place their money, and pooled funds meet their needs far better than separate accounts, according to industry sources.

Global markets tempting

Investment abroad has become one of the most popular choices for U.S. institutions. In total, institutions plan to pour nearly $6 billion into foreign real estate markets in 2006. Additionally, more than 50% of respondents plan to pursue, or are considering investing in, foreign real estate this year, with Australia/New Zealand and India generating the most interest.

The internal rate of return for global real estate investments typically starts at about 15% and can reach as high as 35% for development opportunities, according to industry experts.

“The opportunity to invest globally both in private and public markets has grown substantially,” Price says. “By expanding their horizons outside of the U.S., institutions are finding better opportunities and diversification.”

For example, Price is advising a United Kingdom pension fund that has $700 million to invest in real estate. The institution doesn't want to increase its holdings in the UK, instead preferring to get some global exposure. To that end, ING Clarion Partners has advised the institution to invest 25% of its funds in global REITs and the remaining 75% in equity funds in Europe and Asia.

Many institutional advisors have launched global funds, says Lewis Ingall, executive vice president for Heitman. The firm recently raised $410 million for Heitman European Property Partners III Fund, which will use leverage to acquire more than $1.2 billion of real estate.

Additionally, Heitman has assembled a team in Europe and created an alliance with an Asian firm to focus on global REITs. As more institutional clients look to invest in non-U.S. REITs, Heitman wants to be able to point its clients in the right direction, Ingall says.

U.S. REITs get cold shoulder

Many institutional advisors view non-U.S. REITs as excellent investment vehicles. “Global REITs are an emerging market opportunity — they're a chance to take advantage of globalization, but they're less volatile than other global investments,” Louargand contends. “They're more attractive from a return perspective.”

In fact, Weiss is advising his clients to shift most, if not all, of their domestic REIT investments into global REITs. “Because foreign countries are just now introducing REIT legislation and are in the process of re-pricing their real estate, the yields are slightly higher and the growth prospects are better,” according to Weiss, who adds that his company has taken a different stance on domestic REITs.

“We're not recommending an allocation in domestic REITs right now,” Weiss emphasizes. “We're very concerned about the pricing in the public REIT sector because we think it's priced to perfection — all the upside has been priced in.” Moreover, he points out that many REIT dividends have reached a point where they are lower than the 10-year Treasury yield, which registered 4.74% as of March 26.

Weiss is not alone; the Kingsley survey shows that institutions are decreasing their REIT allocations this year by roughly 100 basis points to 5%, which totals just over $3 billion.

In 2005, the NAREIT Composite Index (which includes mortgage REITs) and the NAREIT Equity Index outperformed most of the major market indexes with returns of 8.3% and 12.3%, respectively.

Real estate mutual funds provided a cumulative return of 11.75% for 2005, according to data provider Lipper, exceeding the overall average U.S. mutual fund return of 6.7%.

Most industry experts are predicting similar returns for 2006, and that's why some advisors aren't overly bearish on REITs. For example, Michael Giliberto, managing director and director of portfolio strategy at JP Morgan Asset Management, has moved from overweighting REITs in 2002 to overweighting private markets today. “We believe that private markets currently offer slightly better relative value for our institutional investors, so we have turned the REIT allocation dial down a bit as a tactical matter,” he says.

“We continue to believe that blends of public and private real estate make a lot of sense strategically.”

Louargand, who acts as an advisor to the Oppenheimer REIT mutual fund, still maintains that domestic REITs should account for as much as 40% of an investor's portfolio.

“We think it's a good time to be in both the private and public markets,” he says, adding that the fund is overweighted in hotels and industrial REITs, as well as a few office REITs.

As for the pricing of REIT stocks, Louargand says that many REITs are still trading at a discount to their true value. “The fact that investors are taking REITs private indicates to me that REITs are still undervalued.”

Jennifer Popovec is a Dallas-based writer

Array of investment funds

Institutional investors armed with capital have plenty of ways to spend it. In fact, there's a real estate fund for just about every type of investor, especially those that are interested in value-added and opportunistic returns.

For starters, institutions can choose open-ended or close-ended funds. Most choose to go with open-ended funds, letting their investment grow as properties are bought and sold within the fund. Each fund has specific hold periods and exit strategies to fit investors' needs, and each uses its own reporting standards.

Some of the newly established funds include Henderson's Global Property Fund, which offers leveraged returns of 12%. The $190 million fund primarily acquires core properties but also features a value-added component. The fund, which uses 50% leverage, has nine properties under management with plans of adding office and industrial properties.

ING Clarion Partners' Lion Value Fund is a value-added investment vehicle. The newly created, open-ended fund invests in value-added properties in North America and currently has $300 million in assets. It focuses on non-core property types that need repositioning. The fund is expected to grow to $1 billion by the end of 2006.

For risk takers, LaSalle Investment Management offers a value-added fund that has a leveraged return of 15%. Peter Schaff, regional CEO for North America at LaSalle Investment Management, says the fund is forced to use $2 of debt for every dollar of equity to achieve those kinds of returns.

The $500 million Income and Growth Fund uses 65% leverage. It has made several buys, including a collection of suburban office properties in Atlanta with high vacancies and an office complex in San Diego that can be redeveloped.
Jennifer Popovec

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