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FEATURE: Measuring up

Though some GPs argue that absolute returns matter most, an industry index allowing anyone to benchmark the performance of value-added and opportunity funds has finally arrived. PERE Magazine December 2008/January 2009

Wanting to measure ourselves against fellow human beings is a natural urge, but in asset management it is a business necessity.

How else can a fund manager know if he offers top quartile performance? How else can an investor be sure he is allocating capital to a star manager and not a dud? In most asset classes, mainstream private equity included, doing the financial equivalent of checking out others in the locker room is relatively straightforward.

Being the more established alternative asset class, private equity has evolved into having a developed system at its disposal. Its younger cousin, private equity real estate, however is still in its infancy. So, it stands to reason there are fewer tools around to measure its progress.

For the first time, an index is being published that allows value-added and opportunity funds to be benchmarked against a real estate industry average.

Yet, a watershed for opportunity funds has arrived. For the first time, an index is being published that allows value-added and opportunity funds to be benchmarked against a real estate industry average. This will satisfy the ego of the best GPs. It might be unwelcome to the worst performers. For the LPs though, it offers an instant chance to assess the real value of the mangers they invest with.

The National Council of Real Estate Investment Fiduciaries (NCREIF) and real estate consultant The Townsend Group, have been working on publishing indices for well over a year. In the last few months, they have finally published the early versions. 

Timing returns

As an organisation, NCREIF has been publishing real estate data since the 1980s, but it only captures unleveraged returns of core property of assets owned by a pool of US institutional investors without even factoring in fees. Now, in conjunction with Townsend, NCREIF is publishing indices showing time-weighted returns, gross and net of fees, for opportunity funds and value-added vehicles.

To address the weaknesses of such a measure for opportunity funds, it is also publishing the more relevant measure – the internal rate of return, sliced up by vintages and breaking down the IRRs by top quartile, bottom quartile and the median performance.

There was nothing out there to evaluate how categories other than core unlevered property
were doing.

Joe D’Alessandro, founder of Atlanta-based Real Estate Insights, who worked on the indices, says the product was created because the industry demanded it. “There was nothing out there to evaluate how categories other than core unlevered property
were doing,” he says.
 
According to D’Alessandro, gathering the data has been a challenge and he is hoping for more participation from fund managers. Nevertheless, the list of contributing firms is impressively long and strong, including The Blackstone Group, Morgan
Stanley, Goldman Sachs, Apollo Real Estate Advisors and Lone Star. In total, there are 178 firms contributing data representing
500 funds.
 
As D’Alessandro explains, the first index shows time-weighted returns of value-added and opportunistic funds vis-à-vis all core property, open-ended vehicles and the NFI-ODCE index, which measures capitalisation and time-weighted returns at the fund level of ope -ended diversified core property investments (previously the closest thing there was to a fund benchmark index).
 
The new NCREIF index, therefore, allows institutions to assess the general risk/return characteristics of the three broad investment styles in real estate. Of course, time-weighted returns, by stripping out the timing of contributions and distributions to and from the fund, are not the most appropriate method of measuring opportunity funds.

As such, they cannot measure the speed with which an investor gets his money back.

However, time-weighted returns cannot be ignored either because for real estate investments, the Global Investment  Performance Standards (GIPS) requires them as the standard industry measurement. It allows chief investment officers to compare apples with apples.

The IRR gives you  performance at the index aggregate level while the TWR gives you an idea of the performance for the asset class.

The NCRIEF/Townsend indices, however, do not rely on time-weighted returns alone. Instead they go further by publishing
the composite IRR of opportunity funds by vintage year, as long as there is a minimum of eight funds populating any given year.
Under the time-weighted return method, the beginning and end of an opportunity fund is equally weighted with the middle period of a fund.

By contrast, the IRR is not going to give much weight to the early period of the fund when negative returns are possible or the end, when there may be some assets left that are not going to contribute much to the performance of the overall
fund. The IRR takes account of this “J curve” effect by weighing returns when most of the capital is invested.

Overall, the addition of IRRs to time-weighted returns in the NCREIF/Townsend index works because “the IRR gives you  performance at the index aggregate level while the TWR gives you an idea of the performance for the asset class”, says  D’Alessandro.

And as the indices become more established, the idea is to begin slicing the data further. Eventually, the aim is to collect data in currencies other than US dollars and, if necessary, break out non-US denominated funds. Also, multiple sub-indices within
each investment style could be reported, enabling a more precise comparison of strategy and asset focus.

Who needs a benchmark?

Generally, the industry is supportive of the NCREIF/Townsend indices. There are similar indices being worked on at INREV, the European Association for Investors in Non-Listed Real Estate Vehicles. Andrew Smith, chair of the association’s performance
measurement and benchmarking committee, says initial results could be fed back next year.

But while welcoming the chance to measure themselves against peers, there are some GPs who question the relevance of
a benchmark index at all. One GP at an opportunity fund told PERE the job of an opportunity fund is to achieve 20 percentplus
returns. “So to say ‘I'm better than the opportunity fund index’ is not as relevant as saying ‘I achieved 20 percent-plus as
we said we would’.” 
 

So to say ‘I'm better than the opportunity fund index’ is not as relevant as saying ‘I achieved 20 percent-plus as
we said we would’.

He added that all GPs would want to outperform their peers, but with LPs on average investing just 10 percent of their real
estate allocations to opportunistic strategies, fund managers can see they are “doing their job” by “significantly outperforming
the main property index adjusted for leverage”. In that respect, benchmarking is best measured against a main index such as that published by the UK’s Investment Property Databank (IPD) with returns of the opportunity funds delivered in order to compare, the manager adds.

Anthony Frammartino, a principal at Townsend, who also worked on the NCREIF indices, argues differently though. “I think there is a need for a benchmark. If you look back over the last five or 10 years, it is really difficult to identify who did well and who was simply rewarded in a rising market.”

NCREIF and The Townsend Group's Index

Delving into IRRs

This chart is taken from the new NCREIF/Townsend indices and shows the IRRs of opportunity funds for the vintage year 2005, sliced up to reveal gross and net of fees and the cash multiples for the top, bottom and median performers. When combined with data from other vintages, it is possible to compare the distribution of IRRs over the years.

Vintage period Net assets (active funds) 20,711
funds started in: Gross real estate assets (active funds) 51,140
2005 Active funds (not 100% complete) 30
Total funds 31
as of 30 June 2008 / ($m) Earliest completed fund 12/31/07
Active and Paired
completed funds Paired gross to
(data since gross to Gross Net net spread Investment
individual fund's Last qtr. Percent net spread realised realised (realised multiple
inception) reported complete Gross IRR Net IRR (IRR) IRR IRR IRR) net
# Funds reporting 31 21 23 22 20 18 10 10 23
Top quartile 6/2008 16% 24.1% 25.0% 5.8% 82.2% 69.2% 11.7% 1.6
Median 6/2008 11% 21.0% 14.5% 4.6% 56.7% 43.1% 7.8% 1.2
Bottom quartile 6/2008 4% 13.0% 7.3% 3.7% 32.8% 23.5% 4.8% 1.1