Besides stocks and bonds, core real estate is the most popular type of asset class for institutional investors when constructing an investment portfolio. Who would not like low risk investments in prime locations, providing predictable cashflows? The cherry on the cake for this type of investment is the implicit promise of capital gains if the holding period is sufficiently long.
Core investors have, lately, been vindicated in their choice. Active core private real estate funds currently fare better in their performance than their value-add and opportunistic peers in terms of multiple of invested capital with respectively 1.48x, 1.35x and 1.31x, based on data we analyzed from Cambridge Associates and eFront Pevara.
But there is more than meets the eye. Core investing is a recent phenomenon, so these performance figures are for active funds only. Moreover, core funds mature more slowly than their value-add and opportunistic peers: the funds in our sample are realized at 34.7 percent for core, 63.1 percent for value-add and 70.5 percent for opportunistic. Longer holding periods explain why time-sensitive IRRs diverge from multiples, with 5.95 percent for core, 7.23 percent for value-add and 7.21 percent for opportunistic funds. It is therefore difficult to draw definitive conclusions.
Still, core is an attractive story, especially after an extended run of good performance combining steady yields and increased valuations. The strategy is fairly well known; assets are readily available and investing does not require rare knowledge. But that makes it also a breeding ground for risks in terms of portfolio construction. Proximity breeds complacency and investor behavioral biases, notably in the areas of familiarity and home bias.
The current and future crop of core funds will not yield returns equivalent to the historical performance driven by favorable investment conditions in the wake of the 2008-09 shakeup. Valuations of plain vanilla assets were particularly attractive. Prices recovered fast and well, boosting the performance of core funds.
Diversification is therefore a must. Value-add and opportunistic strategies come to mind, but are less well known and less readily accessible than core assets. For investors without any specific hands-on experience, delegation is mandatory, but fund manager selection is a challenge. The dispersion of performance is high, and assessments are time-consuming and expensive. Even choosing the right strategy is complex.
The best opportunity
It might come as a surprise that our independent buy-side research recommends opportunistic funds as the main vector of diversification. They target heavy refurbishing or restructuring of assets to achieve significant capital gains. Assets often do not generate any yield at acquisition and during the refurbishment or restructuring process. The holding period tends to vary between four to six years. So, why would this make a good diversifier?
Investors currently in core assets will collect rental yield. But their expectations to generate capital gains are limited. Opportunistic assets provide an inverse value proposal. Moreover, the main risk in opportunistic investing is execution, not asset valuation at acquisition time. Managers are specialized and actively mitigate this risk, but acquire assets at fairly low valuations.
Value-add and opportunistic funds have similar historical multiples, respectively 1.43x and 1.42x, but the IRR of opportunistic funds is higher than for value-add, with respectively 10.5 percent versus 8.76 percent. In terms of risk, opportunistic funds also look surprisingly more attractive. Historically, opportunistic funds lost capital more often than value-add funds – 28.5 percent versus 20.3 percent respectively – but opportunistic funds lost on average 34 percent while value-add funds reached 40 percent. Value-add funds have a wider dispersion of returns than opportunistic funds, with respectively a spread of 1.21x versus 1.82x – core reaches 0.51x. When it comes to the time-to-liquidity measure, opportunity funds seem again more attractive, with four years of average holding, versus 4.4 years for value-add and 7.6 years for core. While some investors, such as defined benefit pension funds, are focused on the very long term, others such as insurance groups favor the realization of capital gains more frequently.
Against all odds, to successfully navigate the reefs of high core valuations, an opportunistic anchor is the best fit. This is one of the surprising findings of our latest Critical Perspectives entitled “Beyond Core: Private Real Estate Investing”, which also investigates the resilience of private real estate during crises.