During its July investment committee meeting, the Orange County Employees Retirement System did something many institutional investors did last year: it pulled money out of core real estate.
In total, the $15 billion California pension moved to redeem $400 million from two open-ended core diversified equity, or ODCE, funds: JPMorgan Strategic Property Fund and Jamestown Premier Property Fund. Its drawdowns contributed to the mounting queue of capital waiting to exit funds in the NCREIF-ODCE index, which was nearly $20 billion at the end of the third quarter of 2020. Meanwhile, $14.4 billion did make it out of the index’s funds to investors through redemptions and distributions last year, resulting in a net outflow of $2.7 billion.
The movement to withdraw from struggling ODCE funds has been underway for years. In 2019, the index saw $19.9 billion of distributions and redemptions for a net outflow of $1.9 billion. OCERS, for its part, requested a full redemption of its $169 million investment in the ASB Allegiance Real Estate Fund that year. But the trend, like so many others, has been accentuated by the pandemic, which struck hard against core real estate’s Achilles’ heel: offices and retail assets. These account for roughly half of the NCREIF ODCE index.
“Pre-pandemic, managers got extra points for specificity, for having existing portfolios with lower basis, seasoned assets. But now, that’s a huge problem,” Jeff Giller, global head of real estate at the advisor and asset manager StepStone, tells PERE. “Considering going into a core fund means taking into account if they’ve taken appropriate write-downs for the market and if they’ve written down enough.
“Investing in an ODCE fund is buying the past and not knowing how it will perform in the future,” he adds.
Still, core remains the strategy of choice for private real estate investors. Already accounting for more than 80 percent of institutional portfolios globally, it was the preferred style of investment heading into 2021, even in the US, where risk tolerances tend to run highest, according to surveys from the industry groups PREA, INREV and ANREV. The question is: how will investors access core moving forward?
Through interviews with 19 managers, investors, consultants, capital advisors and researchers that engage with and monitor the core sector, PERE has found that the bedrock of private real estate has now arrived at a crossroad it had been inching toward for years. The strategy is as important as ever, but its fundamentals have changed. No longer is simply investing in the best assets in the biggest markets a sufficient approach. Demographics have shifted, occupier preferences have changed, and underlying financials challenge long-held assumptions about what belongs in a core portfolio. Though not new, these realities have been laid bare by the pandemic.
“We’re going to see some of the traditional definitions that have been utilized challenged going forward,” Laura Huntington, head of Seattle-based Institutional Property Consultants, tells PERE. “That’s going to open up a broader set of opportunities in the core space and how we view core assets within a core investing style.”
What’s in a name
In a 2017 white paper, the Meketa Investment Group defined a core fund as being comprised of office, retail, apartment or industrial assets that are at least 85 percent leased at acquisition, have no more than 40 percent leverage, require minor capital improvements and derive at least 70 percent of returns from income. They are also, by the consultancy’s definition, located in primary markets – those being New York, San Francisco, Los Angeles, Chicago and Washington, DC in the US, as well as global capitals in Western Europe and mature parts of Asia.
While parts of that definition are generally still agreed upon, such as the use of leverage and focus on income returns, there are now conflicting opinions about other components. “There is a lot of debate about whether asset type and geography are part of the definition of core, or if it’s just about active management,” Will Robson, executive director and global head of real estate solutions research at the data firm MSCI, tells PERE. “The industry is missing very tightly defined definitions in this area and it has been for a while.”
The complexion of core funds varies widely across regions. In continental Europe, for example, industrial assets make up 45 percent of assets, according to MSCI’s third-quarter 2020 data, but only 28 percent in the UK, 25 percent in the US and 14 percent in Asia-Pacific. Residential, meanwhile, is only a significant sector in the US at 26 percent of the index – the other three regions each have less than 5 percent exposure to the property type. The only market where core funds are substantially exposed to assets other than the four primary ones is the UK, but that is due largely to heavy hospitality and leisure exposures.
Some judge an investment’s core potential simply by its return profile. “Core today, given where pricing is, regardless of asset class, would be net returns after tax and fees of around 4 or 5 percent with an element of prudent leverage of 30 to 40 percent, maybe 50 percent,” Kiran Patel, chief investment officer at London-based Savills Investment Management, tells PERE. “Then you can go into the characteristics of the asset – location, spec, lease length, covenant rating – and the less volatility you can facilitate there the better.”
Others view it as simply a measure of what is most desirable in the market – a barometer that does not always point toward stable returns. “What is considered core is what everybody wants,” Stephane Theuriau, head of London-based BC Partners Real Estate, says. “Right now, I think there are some assets that people believe in that are priced as core with underlying operational challenges that are not core because it is the story everybody believes.”
Theuriau says only a “small minority” of assets qualify as truly core, and identifying them has become even more challenging now that rental growth in the largest property type, office, is poised to be negative for the years ahead.
The Washington State Investment Board, which manages $128 billion on behalf of the state’s public sector pensions, does not use the term core at all, nor does it use value-add or opportunistic for its higher-risk investments. Steve Draper, the senior investment officer who oversees the organization’s $21 billion real estate portfolio, tells PERE this is because the terms do not align with how WSIB assesses risk.
However, income-oriented strategies make up between 70 and 80 percent of the WSIB’s real estate portfolio, which is comprised of equity stakes in operating companies. Like other investors, it has limited its exposure to secularly challenged property types in recent years. Office makes up just 4 percent of its overall portfolio, with three quarters of that exposure held in a single project. And it has just one mall, purchased as a redevelopment site.
Draper says the definition of core has long varied from firm to firm and over time. “Investors’ views of what constitutes ‘core’ property has evolved over the past few cycles,” he says. “Relatively fewer investors used to like industrial, and multifamily wasn’t always considered to be highly institutional. I suspect other property types will continue to gain acceptance as having appropriate risk to be considered ‘core.’”
CIM Group is the newest member of the ODCE universe, with its CIM Urban Income Investments being added to NCREIF’s index at the end of 2020. Jolly Singh, a managing director for the Los Angeles-based firm’s portfolio oversight group, says his firm brings a new approach to diversified core investing.
Checking the assumptions
CIM’s strategy begins by identifying strong neighborhoods – regardless of what city they are in – and looks to address their biggest real estate needs, Singh tells PERE. Traditionally, managers have taken a top-down approach to portfolio construction, he says, focusing on gateway markets that were perceived to be the most stable, because of their liquidity and depth of tenants. But that view runs counter to migratory shifts away from high tax and high cost of living states, such as New York and California, to cheaper locales such as Texas, Florida and Colorado, he argues.
“Migration out of gateway markets has been emphasized post-covid but is a trend that has been happening for 10 years,” Singh says. “While we continue to see opportunities in gateway markets, our view is the perceived lower risk of gateway markets without taking into context the changing demographics, population movement and employment trends that are happening in the US, is a difficult posture to maintain.”
In 2018, MSCI published a white paper exploring the safety of investments in global gateway cities versus regional gateways and nationally significant cities. It found that while investments in the top markets tended to have higher returns driven by appreciation, the performance of those assets were more volatile than their counterparts in smaller cities.
Geographic preference is not the only place where the foundational principles of the ODCE index come up short. Traditional property types, particularly malls and offices, tend to be more expensive to maintain than self-storage and healthcare assets, with capital expenses accounting for 20 percent or more of net operating incomes, according to a 2019 report from Green Street Advisors.
Amy Price, president of BentallGreenOak, another ODCE fund manager, tells PERE her firm has been reducing its exposure to office for the past five years because the cost of ownership was dilutive to overall returns. In particular, she says major urban office markets look to be the most challenged moving forward.
“If you own a core portfolio including office and multifamily, you are looking for more diversification by market and by segment than you were even five years ago,” Price says. “The bias used to be that a core asset was an urban high-rise building in Manhattan. Today, if you have a core strategy in multifamily, you want those urban high-rise assets to be less of your portfolio and you also want to own low and mid-rise in the south and south-west, areas that would not have been considered core in the past.”
To Price’s point, high-rise apartments saw the lowest total returns among residential assets tracked in the MSCI/PREA ACOE index last year at 0.3 percent. Low-rise apartments were close behind at 0.8 percent. Meanwhile, garden style apartments delivered a total return of 5.3 percent.
In North America, 42 percent of investors said core was the most attractive investment strategy in 2021, according to PREA’s annual Investment Intentions Survey, the highest rate since at least 2014. In the Asia-Pacific region, 43 percent favored core over opportunistic and value-add, and in Europe, fully half of investors were focused on low-risk strategies.
With global interest rates at record lows and poised to remain there for the foreseeable future, the steady returns of core real estate are widely seen as a superior source of beta than fixed-income instruments. But in 2020, the NCREIF ODCE Index fell short of that mark, closing the year with a one-year net of fees return of 0.34 percent, while 90-day US Treasury bills returned 0.53 percent. That underperformance was driven more by the depreciation of office and retail assets than diminished income. But until there is more clarity about the prospects for those property types, hardship in the ODCE space is unlikely to abate.
“It will take a couple years for all of us to come back to our offices and figure out how we use those spaces,” Lori Campana, a managing director at the Boston-based capital advisory Monument Group, says.
Investors with the resources to do so have opted to build their core allocations through direct investments or non-fund structures.
Draper says the WSIB gets exposure to low-risk properties by investing in operators that own those types of properties as well as by developing them new. “We like adding to the
lower-risk part of the portfolio because, ultimately, we are trying to maintain a long-term, high-quality, stable income stream,” he says. “Our role is to pay benefits to retirees, and we achieve that best through income production. We can’t pay benefits with unrealized IRR.”
Another group that favors direct core exposure is QuadReal, the real estate arm of British Columbia’s public sector pension investor. It has a
long-term target of investing 20 percent of its portfolio – currently north of C$40 billion ($31.4 billion; €26 billion) – to alternatives, including data centers, labs and life sciences, healthcare real estate and manufactured housing, Jeffrey Munger, the group’s head of US research, says.
Munger adds that investing in non-traditional properties has been accretive to the Canadian investor’s returns. But he notes that its expertise in these areas dates back years, or even decades, and did not come easy or cheap. “It’s not something to be approached in a foolhardy manner,” he says. “You have to put the time into doing the research, understanding the opportunity and really being specific about how this alternative investment can supercharge, or in some cases, increase your risk exposure to some of the more core elements of a portfolio.”
Ben Maslan, managing director at Maryland-based RCLCO Real Estate Advisors, advises his institutional clients to build their own core portfolios by investing in, or alongside, operating companies. Doing so allows them to get greater access to niche sectors such as self-storage, single-family rental, medical office and life sciences than would be available through a diversified fund, he tells PERE.
“As we consider portfolio construction, most of our clients have the ODCE as their benchmark but given our clients’ investment objectives and risk appetite, we try not to anchor their portfolios to the ODCE,” Maslan says. “Instead, we recommend a demand-driven approach, which includes property types that are not necessarily what the ODCE has in its portfolio. That leads to some tracking error relative to the benchmark, but what we project will be out-performance long term.”
However, for many small and mid-size institutions, particularly those with limited in-house investment teams, commingled funds remain the only practical way to build a diversified core portfolio. Even OCERS, which is looking to reduce its weighting to core real estate, committed $250 million to Principal Real Estate Investment’s Principal US Property Account last March.
It is also a common occurrence, market sources tell PERE, for investors to redeem capital from one ODCE fund and redeploy it into another. And though it pales in comparison to the exit queue, there was a backlog of $4.5 billion of new commitments waiting to be admitted to ODCE funds.
Diversification through specialization
Despite the net outflows of investor capital in recent years, the NCREIF ODCE index continues to grow. What was 18 funds managing $84 billion of net assets in 2012 has ballooned to $224 billion across 26 funds.
That expansion says nothing of the various single-sector core and core-plus funds that are on, or coming to market, targeting industrial, multifamily, even more specialized sectors such as self-storage and life sciences.
Andrew Mitro, a managing director in StepStone’s consultancy business, says the core real estate sector has skyrocketed during the past decade. In the fourth quarter of 2010, his firm only kept tabs on the 17 funds that were in the ODCE index at the time. In 2016, StepStone began to monitor the broader core space, which now includes 58 funds, Mitro says, with a new fund being added nearly every quarter. “There are so many more options now,” Mitro says. “The control is in the investors’ hands to create their own diversification rather than only being able to invest in a blind pool of everything.”
One investor looking to take advantage of that opportunity is Tokio Marine Asset Management. Prior to the pandemic, the investment arm of the Japanese insurer had its sights set on cross-border expansion in the US and Europe through ODCE-style funds. Now, its vehicle of choice is a core fund focused solely on industrial or residential, head of overseas investment Shinji Kawano tells PERE, “because of the current uncertainty in retail or office.”
The risk-averse investor is also eager to get exposure to property types that have flourished during the pandemic, such as data centers and life science assets, but, so far, has been disappointed by the selection of private-market options. “We are keen to invest in those emerging property types, but execution is a challenge,” Kawano says.
“I understand those opportunities are primarily in a format of listed or non-core, while we prefer to invest in non-listed, core vehicles. Therefore, so far, we have invested in those sectors much less than what we wanted to. We long for new funds, hopefully in the open-ended core format, which are focused on those sectors.”
Several specialized core and core-plus funds have hit the market in recent years. Since 2019, Nuveen Real Estate has launched open-end vehicles targeting US multifamily, US industrial and European logistics. And last year, Tishman Speyer and Blackstone both launched life sciences platforms – the former via its spinout Breakthrough Properties, the latter via a $14.6 billion recapitalization of its investment in BioMed Realty.
With Blackstone Property Partners Life Sciences, the New York-based mega-manager now has five perpetual-life vehicles under its management. During the firm’s fourth-quarter 2020 earnings call, president and chief operating officer Jon Gray said Blackstone increased its core-plus platform by 50 percent year-on-year to $69 billion of assets.
Nadeem Meghji, Blackstone’s head of Americas real estate, says the firm has used these vehicles to meet investor demand for steady, income-producing real estate. “You see a greater desire among investors to own assets that produce growth, whether it’s life sciences, industrial, studios or multifamily in higher growth markets,” he tells PERE. “It’s less about the definition of core and more about more investors tilting toward growth, and that’s the way in which we invest as well. Our entire focus is to emphasize within our own portfolio places where we see the highest growth and best long-term supply and demand fundamentals.”
The new core
Open-end core fund managers are aware of the shifting forces in real estate. They are adjusting their portfolios, albeit slowly. Over the past five years, funds tracked by the MSCI/PREA ACOE index have reduced their office and retail exposures by approximately 6 and 5 percentage points, respectively. At the same time, the industrial share of the index is up 9 percentage points and the share of alternatives, though still a small part at 1.7 percent of the index, has more than doubled.
The lethargic pace of progress is partially by design, partially by force and wholly unavoidable, Huntington, who teaches portfolio construction classes for NCREIF seminars, says. On one hand, funds that are in the NCREIF ODCE index cannot deviate too widely from the allocations of their peers, or else they risk tracking errors, she says. And on the other hand, funds coping with long redemption queues have little flexibility to acquire or develop new assets.
However, the long-term secular trends reshaping the real estate industry – technological innovation, urbanization, and the aging of population groups – will force the funds in the index to change sooner or later. “We’re still in the early stages of a long-term process. But I would expect a portfolio in 2030 to have a larger component, if not 50 percent of the portfolio, including different property types, than what we have today,” Huntington says. “They will be focused on alternative housing, health care and the technology sector to represent what’s going on in our demographic evolution.”
Because of their sheer size and the fact that smaller investors rely upon them, the diversified core funds of the world will remain pillars of the private real estate industry. But until the indexes they comprise reflect the contemporary market trends, the space will continue to be bifurcated into those with exit queues and those with entry queues.