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Hodes Weill: RE target returns likely to decline

With real estate valuations at a high point in the cycle, hitting targets may become more challenging over the next five years, said the New York-based advisory firm’s annual investor allocations report.

The average target return currently stands at 8.2 percent globally, but that figure is expected to be reduced over the coming years, according to the 2015 Institutional Real Estate Allocations Monitor from New York-based advisory firm Hodes Weill & Associates and Cornell University’s Baker Program in Real Estate.

“It may be expected that target returns will decrease over the coming years as institutions reassess their long-term return expectations for their investments, including real estate,” the report’s authors, Cornell’s Dustin Jones and Hodes Weill’s Douglas Weill and David Hodes, wrote. The California Public Employees Retirement System, for example, currently is considering a reduction in its overall target return on investments from 7.5 percent to 6.5 percent over the next 20 years, which would in turn affect its target returns in real estate, the writers noted.

“Institutions have significantly outperformed target returns in the last cycle, but maybe in the next 4 to 5 years, it’s going to become more challenging, given how far real estate has come from valuation standpoint,” Weill said in an interview with PERE.

The institutions with the highest target returns were endowments and foundations, with current target returns averaging 8.9 percent, while the investors targeting the lowest returns were sovereign wealth funds (SWFs), at 7.4 percent, according to the report. Interestingly, SWFs actually achieved the highest three-year average return at 13.3 percent, or 590 basis points over their current target return.

According to Weill, the high returns were partly the result of when the capital was deployed, since annual returns have increased significantly over the past three years. Another factor was the fact that sovereign wealth funds typically have invested in hard-to-access markets like New York, Paris and San Francisco. “You need scale in those markets and that’s where yields have compressed the most,” he said.

Geographically, institutions in the Americas had the highest target returns at an average of 8.6 percent, compared with institutions in Europe, the Middle East and Africa, at 7.1 percent. “This may be attributed to institutions in the Americas investing higher up the risk curve and institutions in EMEA investing in real estate as an alternative to fixed income and preferring lower levels of leverage,” the report said.

One consequence of the expected moderation in real estate returns is that some institutions have been shifting away from real estate and into alternative asset classes, with a noticeable increase in allocations to energy. In fact, energy was an alternative strategy to real estate for 30 percent of institutions with less than $50 billion in assets under management (AUM) and 36 percent of institutions with more than $50 billion of AUM.

Institutions have found energy to be an attractive alternative because of the repricing of assets and expectations of distress in the asset class over the past year, according to Hodes. “For people chasing yield, they’ve backed off of real estate and pivoted to energy,” he said. “They’re saying, ‘there’s nothing wrong with real estate, the returns will be okay, but we’re targeting 20 percent returns, and we’re not convinced real estate is the best place to do that right now.’”

The Institutional Real Estate Allocations Monitor, which will be widely released later Wednesday, was based on survey responses from 242 institutional investors in 30 countries. In addition to historical and target returns, the research also covers target and current allocations to real estate, investor sentiment, risk preferences, investment product trends, investment strategy preferences, as well as environment, social and governance policies.