One of the oldest and most successful open-end diversified core real estate funds in the market, UBS’s Trumbull Property Fund, stands as a testament to what happens when the model goes awry.
Launched in 1978, the fund discloses $25 billion of assets in its most recent filing with the Securities and Exchange Commission. Its gross rate of return since inception is 8.9 percent, according to a meeting document from the US pension plan Ventura County Employee’s Retirement Association. The return beats the industry’s leading benchmark, NCREIF’s ODCE fund index, by 23 basis points.
However, the Swiss bank’s marquee core fund is dealing with a steadily growing queue of redemptions, which, at last count, neared $4 billion, according to sources familiar with the fund. Some investors will have to wait years for their capital to be returned. The more investors tap out, the more assets must be liquidated, meaning less capital for UBS to return to its remaining investors, incentivizing them to, in turn, trigger their own exits. With outside investors reluctant to subsidize those departures, new commitments have not been able to match redemptions, prolonging the delay.
UBS Trumbull is a stark example of what can happen when investor sentiment turns against an open-end real estate fund. But it is not the only struggling diversified core vehicle in the market. Others, particularly those in the US market, face notable redemption requests and sector returns have diminished over the past five years.
Investor perspectives
California Teachers’ Retirement System
$30bn Real estate allocation
$20bn Core exposure
ODCE outlook: “ODCE funds have a place in many people’s portfolios. For large investors with programs such as ours they may have a diminished role, but we have a number of ODCE funds in our portfolio and after the [global financial crisis] when prices of real estate seemed high relative to ODCE funds, we made commitments to them. They still have a role. It might be a diminished role for us, but they have a very strong role for people to invest in private real estate.”
-Mike DiRé, head of real estate
Joe Azelby, UBS’s head of real estate, declines to comment on Trumbull’s redemption queue, or the efforts to reposition the fund. However, he acknowledges that allocations to ODCE index funds are tapering off as projected returns have faltered after several years of strong post-global financial crisis performance.
“Investor interest in ODCE funds ebbs and flows based on capital market conditions, interest rates, strategic and tactical allocation changes and risk appetite,” he tells PERE. “It’s been a great run for core real estate and returns in this area will likely be lower going forward.”
Through interviews with 18 investors, managers, consultants and research firms, and review of various US public pension investment documents, PERE has found a broad rebalancing of core portfolios is taking place. Many investors are working to align their allocations with market trends. Typically, this means pulling out of funds that lean heavily on retail and office assets in favor of those with more industrial and multifamily biases.
“There’s been an unusual amount of variability in returns between ODCE funds and that has caused consultants and their clients to look more closely at portfolio construction,” Jim Garvey, portfolio manager of Chicago-based LaSalle’s open-end LaSalle Property Fund, tells PERE. “It seems there is more reallocation in this space than normal.”
These portfolio changes reflect a more hands-on approach taken by US investors. Oftentimes at the advice of their consultants, more institutions are exerting greater control over their real estate holdings. The market has responded by offering regional and sector-specific core funds, some of which fall outside the four traditional property types. These open-end vehicles also appeal to non-US investors interested in building low-risk portfolios without being locked into a specific diversification plan.
A growing number of midsize US institutions are following the example of their larger peers by moving away from funds altogether and hand-picking core investments through joint ventures and separately managed accounts. “Investors don’t need to have a $30 billion real estate portfolio to implement a direct strategy,” Ben Maslan, managing director of the Los Angeles-based consultant RCLCO Real Estate, says. “You can implement such a strategy with the right managers and the appropriate amount of leverage with $2 billion.”
Nonetheless, the US ODCE universe continues to expand despite the growing indifference of some domestic investors. The total market was at $202 billion of net assets in Q2 this year, up from $190 billion in Q2 2018 and $169 billion in Q2 2017. The consensus is this trend will continue for the foreseeable future, especially as more Asian investors, keen on open-end structures, enter the US market.
However, UBS Trumbull’s travails serve as a reminder that perpetual-life structures can bring challenges. As investor preferences change and new products come to market, ODCE funds could find their allure diminishing further in the years to come.
Core changes
Core property remains crucial to most institutional investment strategies. Almost 80 percent of real estate assets globally are regarded to be core, according to the Pension Real Estate Association’s 2019 Investment Intentions Survey. Among the survey’s Asia-Pacific investor respondents it is more than 90 percent.
Yet, not all core assets or allocations are equal. US investors are exiting vehicles that are overweight in sectors or locations that break with their view of the market. The top reason given for Trumbull’s redemptions is its exposure to retail properties, which account for 23 percent of its portfolio, compared with 17 percent for the NCREIF ODCE fund index.
In light of the well-documented struggles of second- and third-tier malls, investors want to limit exposure to retail assets, which delivered a total return of -0.11 percent during the second quarter, according to the NCREIF Property Index. Demand is shifting toward logistics properties to take advantage of rising e-commerce activity. Accordingly, Trumbull’s returns, which lagged the ODCE index by 1.4 percent over the past one-, three- and five-year periods, according to VCERA meeting documents.
“Within and even beyond ODCE, we have investors with an increased appetite for strategies that can give them exposure to high-quality residential and industrial assets in their portfolios,” Bernie McNamara, co-head of investor services and solutions at Los Angeles-based manager CBRE Global Investors, tells PERE.
Some investors raise other issues with Trumbull’s allocation. The Illinois State Universities Retirement System flagged the fund’s hotel allocation as one reason for its $380 million redemption request in 2018. In its 2020 investment plan for the San Diego City Employees’ Retirement System, Townsend Group, an Ohio-based consultant, recommends the pension continue its withdrawal from Trumbull citing “historic underweight to outperforming Pacific region [and] office portfolio underperformance.” SDCERs has redeemed $45 million from the fund so far and hopes to get the remaining $34 million in six or seven quarters, according to the July meeting document.
UBS’s fund bears the brunt of the damage, but other ODCE funds with similar portfolios face redemption requests and have been placed on investor watch lists because of their similarly shaky performances. SDCERS is also eying an $85 million redemption from the AEW Core Property Trust. Townsend recommends the move based on an overweight to retail and performance that lags the ODCE index. Like other investors, SDCERS hopes to deploy its redeemed capital into other core vehicles, targeting a $65 million ODCE investment and a $50 million core-plus investment later this year.
Investor perspectives
Oregon State Treasury
$8.5bn Real estate allocation
$5.5bn Core exposure
ODCE outlook: “For our portfolio construction, ODCE funds play a critical role. They’re our lowest levered, highest quality core, so I build the rest of our portfolio on outperforming the ODCE funds by adding risk, such as increased leasing risk, development or a little more leverage. I’m a spread investor and being a spread investor to the index is a way to build your portfolio so you control where your risks are in the rest of the portfolio. The ODCE index and the ODCE funds have good governance structures and as long as they aren’t wandering from those, I can build a portfolio then layer on risk above that to outperform.”
-Anthony Breault, senior real estate investment officer
The Ohio Police & Fire Pension Fund is undergoing a similar core portfolio reconstruction. In August, it approved redemptions of $40 million and $25 million, respectively, from the JPMorgan Strategic Property Fund and Heitman America Real Estate Trust. It plans to redeploy to LaSalle’s US Property Fund and Morgan Stanley’s Prime Property Fund, two of the biggest winners of the ongoing ODCE shuffle – both have commitment queues of $1 billion or more, according to a source familiar with their fundraising efforts.
Garvey says LaSalle pivoted toward industrial and multifamily with the expectation that those assets would perform better in a downturn: “There’s been a lot of discussion about how long the economy’s been growing and the potential for this business cycle to end, so in anticipation of that, not knowing when it will happen, we moved to a more defensive stance a few years back,” he tells PERE. “The economy continues to grow, but there are a number of macroeconomic risks that are evident.”
Lower returns
Through the four quarters ending on June 30, the NCREIF ODCE index tracks a total gross return of 6.4 percent, down from the 7.5 percent at the end of the previous quarter. In 2015, the index delivered 15 percent returns before falling to 8.7 percent in 2016, 7.6 percent in 2017 and 8.3 percent last year. Among the weakest funds, the decline is steepest, tumbling from 13.9 percent in 2015 to just 5.3 percent this year.
Historically, ODCE funds have delivered returns in the high single-digit range. Since inception, NCREIF tallies a return rate of about 8.7 percent. However, double-digit returns were common during much of the previous decade, particularly in the years immediately before and after the global financial crisis. Even in the doldrums of 2008 and 2009, the funds in the index retained much of their income and value, thanks to the stability of their properties and their minimal use of leverage.
Christy Fields, managing principal of Massachusetts-based consultant Meketa Investment Group, says diminished returns are not surprising: “Appreciation was terrific coming out of the global financial crisis, but no one would expect these core vehicles to produce teen returns through all parts of the cycle.”
Investors are still drawn to real estate, Fields says, because returns remain strong compared with interest rates, which are exceptionally low in mature markets. “People feel good about real estate. It’s just the things on the margin that are driving these decisions around rebalancing and redemption”
Some investors are fine with lower returns. Shinji Kawano, head of overseas property investment at Tokio Marine Asset Management, tells PERE the institutional capital his Tokyo-based firm invests has no problem with the risk-adjusted returns being produced by ODCE vehicles.
“We are fine with lower returns,” he says. “Japanese pension fund schemes, their typical expected return is between 2 percent and 3 percent, so they don’t need double-digit returns by investing in real estate. On the local currency base, 6 percent to 7 percent is sufficient.”
While the current ODCE market pales in comparison with the heady years around the GFC, that era has contributed to the space’s continued vibrance, Andrew Mitro, a principal at StepStone, tells PERE.
In response to risky practices that lead to the downturn – speculative development, a reliance on recourse debt and subprime lending – many investors have adopted a more conservative approach to real estate, he says: “What you see now is investors typically have a larger core-to-core-plus allocation than they did pre-GFC. We advise one public pension plan that, prior to the GFC, was 30:70 core to non-core and out of the GFC that flipped to 70 percent core, 30 percent non-core because they didn’t want the volatility of those non-core investments. It comes down to an investor’s goals for real estate and the risks it’s willing to take to achieve them.”
A new twist on core
The California State Teachers’ Retirement System, for example, has a 65 percent allocation to core, equaling roughly $19.76 billion of its $30.4 billion real estate portfolio, according to its most recent semi-annual report. Just 17 percent of its holdings are in open-end funds compared with 33 percent for joint ventures and 30 percent for separate accounts. The Sacramento-based pension has bested the ODCE index by 2.4 percent, 2.6 percent and 2.3 percent over the past one-, three- and five-year periods.
Investor perspectives
Tokio Marine Asset Management
$4bn Real estate allocation
$1bn+ US core exposure (50% ODCE)
ODCE outlook: “Our strategy reflects Japanese investors’ very conservative, risk averse appetite so we predominantly invest in core funds. Our primary focus is still diversified in terms geography and sectors, so ODCE-like funds are our main target. But in terms of the sector allocation, we want to allocate more to industrial or residential and underweight retail, so only investing in ODCE funds is not sufficient enough for us to hit our target allocation, so we have committed to several sector specific funds as well.”
-Shinji Kawano, head of overseas property investment
While CalSTRS and its peers are no longer adding capital to their open-end core fund allocations, Mike DiRé, the pension’s head of real estate, tells PERE that ODCE vehicles remain a crucial tool for smaller investors looking to build real estate portfolios. He also notes that the large diversified funds are evolving to meet investor demands for strategic diversification. “They’re offering more options now,” he says. “They’re differentiating from each other more, so if you want an overweight toward a certain product type or area of the country, you can do that analysis and that data is a lot more available. You can pick and choose these funds and even specialized funds.”
Nuveen Real Estate, a London-based manager, has taken this desire for customization to heart and is reconstructing its core platform accordingly. The firm has replaced its open-end diversified US Cities Fund with its Global Resilient Cities series, comprised of six region- or sector-specific open-end vehicles, one apiece for European cities, Asia-Pacific cities, US retail, US multifamily, US industrial and US office.
When Nuveen sought to restructure its core offering in 2016, it found that a segmented approach would allow investors to build up exposures to their liking, US chief investment officer Carly Tripp tells PERE. “It became apparent that there were advantages to that specialized approach versus a generalist approach,” she says. “It was the outperformance along with investor demand, the ability to allocate across sectors, whether their intention is to replicate the ODCE with their investments, or overweight to one or more sectors.”
CA Ventures, a Chicago-based manager, is taking a similar tack with its new open-end fund, CA Student Living Income and Growth, though it is focused on a single asset class: student housing. “Investors want specialists and sharpshooters,” Nishant Bakaya, the firm’s chief investment officer says. “Today, investors are sophisticated; they should be able to say, ‘I want a student housing focused core fund’ or ‘I want a senior housing core fund.’ They should be able to moderate their exposure as they see fit.”
For decades, open-end diversified funds have dominated core investment in the private real estate space, attracting dollar-denominated capital by the tens of billions. But as investors prioritize customization and more managers introduce products to meet that preference, ODCE vehicles may lose their industry clout. However, the ability for investors of all sizes to gain market-wide exposure with a single check is an attribute yet unmatched by other structures, thus securing ODCE relevance for the foreseeable future, Jay McNamara, head of real estate at the research firm MSCI, tells PERE.
“It may shift and change, but I can only imagine a world where committing to commingled core vehicles remains an important part of any institutional real estate asset allocation, whether it’s a defined-benefit US state plan, or the largest pension in the world,” McNamara says. “It’s always going to play an important role because of the time horizon for the risk-adjusted forecasts and exposures they’re looking to achieve.”
Core appetite remains strong, despite diminished returns
Even with falling returns, global investors still want to add core exposure, according to the 2019 Allocations Monitor, an annual survey of investors conducted by Cornell University’s Baker Program in Real Estate and Hodes Weill & Associates, the New York-based advisor.
Of the more than 200 respondents, 66 percent say they want more core exposure this year, compared with 63 percent last year. The same report shows investors’ interest in opportunistic assets fall for the first time in five years, with just 69 percent of respondents targeting the space, the lowest rate since 2015. Value-add is still the consensus strategy of choice, but core investment remains especially popular among pensions and sovereign wealth funds from outside the US.
Respondents from the Asia-Pacific region had the lowest risk tolerance, with 80 percent saying they would like to add to their core exposure against just 40 percent seeking opportunistic strategies. Shinji Kawano, head of overseas property investment at Tokio Marine Asset Management, a Tokyo-based gatekeeper for some of Japan’s biggest institutional investors, says open-end core funds are more popular among Japanese investors for two reasons: “One is we don’t like blind-pool investment. We heavily rely on the expertise of managers. But we want to look into the existing portfolio before committing to the fund. The second point is Japanese investors need to form internal consensus to make decisions, take a lot of time and the Japanese pension funds typically can make major investment decisions only once or twice a year, so they aren’t likely to meet the deadline of a closed-end fund timeline.”
Reliance on core real estate is nearly universal among institutional investors, but the appreciation of the open-end structure is less consistent. Just 51 percent of investors want to commit capital to an open-end vehicle, down from 56 percent last year. Closed-end funds are the vehicle of choice with 80 percent of investors preferring the structure, but that is down significantly from last year’s 93 percent.
Meanwhile, direct investments and separate accounts are trending up, adding 5 percent and 3 percent more investors apiece. At 38 percent and 34 percent each, they are the least used structures, but that is largely because they can be cost prohibitive. “There’s a significant resource demand internally,” Andrew Mitro, a principal at advisory firm StepStone, says. “Without a team to underwrite deals, or a decision-making process that fits the strategy, it can be difficult. It also requires a lot of capital.”
Among investors with at least $50 billion of assets under management, 50 percent targeted direct acquisitions, 64 percent sought separate accounts and 69 percent favored joint ventures. Most large investors still have allocations to ODCE funds, but few are leaning on them to grow their core exposure. While ODCE funds offer more favorable fee structures than closed-end vehicles, several investors point to a preference for a closer alignment with their managers for better economics and greater portfolio control.
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