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American Realty Advisors: core funds need more scrutiny

The real estate investment manager counsels investors to drill into the potential risks of what is typically viewed as a safe investment vehicle.

A new report from American Realty Advisors (American) recommends that investors not assume because various core funds have the same strategy label they have the same underlying risk profile.

In the report, “What’s in your Core Fund?,” the Glendale, California-based real estate investment manager said that the types of investments within core funds can vary significantly, leading to the need for solid investor analysis.

“Often we see investors spending a significant amount of time speculating about what they can’t control – when the next recession will occur, whether prices have peaked, or concern about interest rate increases,” the report said. “Instead, it may be more effective for investors to focus on what they can know – the contents of the funds in which they invest and how their strategies will perform in various economic environments.”

American, which manages about $7.3 billion in assets, noted that allocations to non-core investments may be higher in some core funds than expected, with development accounting for almost 15 percent of the capital invested in one core vehicle. However, most funds do not have significant allocations to out-of-strategy assets, with the median allocation to non-core activities among funds in the Open End Diversified Core Equity (ODCE) index at 5.1 percent.

“The primary role of a core fund is to be a stabilizer within an investment portfolio, not the alpha generator,” American wrote. “When nearly 15 percent of your fund is invested in non-core strategies, the fund starts to look more like a hero fund than a Steady Eddie fund.”

The firm also underscored that while development can be used selectively to reduce the basis in investments, not all development is created equal. Entitlement risks, for example, should not be problematic when the necessary zoning and building permits are in place and leasing risks can likewise be mitigated with proper planning through preleasing and smart location choice. Core funds should limit or, preferably, eliminate cost overrun risk by undertaking development only when a completion guarantee is in place. Risk associated with development length can also pose a threat to returns because long-term developments can expose the project to an economic downturn.

Given the potential risks associated with non-core investments in core funds, the firm stressed the need for investors to more carefully assess the core funds in their portfolios.

“While it has been counseled to know thyself, it’s not a bad idea to know thy core fund too,” American wrote.