Lower return targets for funds are a sign of the times

An interesting conversation that PERE had this week was about Sares-Regis, a US value-add multifamily fund manager said to be bringing its third fund to market.

The interesting part? For the second time in a row, the firm is believed to be lowering the fund’s return target: while its debut fund had a gross return target of 18 percent, the target slipped to 16 percent for Fund II. It is expected to go slightly lower for Fund III.

The reduced target is a reflection of the changing private real estate market since the firm raised its first fund in 2013. Pricing has tightened considerably, with cap rates in US commercial real estate hitting record lows, all the while the amount of competitive capital has increased, particularly from new domestic and foreign investors entering the space in search of greater yield.

Against such a backdrop, Sares-Regis faces the dual challenge of not only finding investments that meet a higher-return profile, but doing so within a limited timeframe. By reducing its target, the manager is indicating it would rather pay a little more for assets, consequently generating lower returns, in exchange for getting capital out sooner. Indeed, PERE understands the firm has deployed more than 80 percent of the capital in Fund II, whose final close was a little over a year ago.

This contrasts with other managers that are trying to maintain the same return targets they have had historically, but may hold off on investing their funds’ capital because of the challenging investment environment at present. While some may view this delayed deployment as a sign of the manager’s discipline, it can also create a significant early drag on returns, with the manager running the risk of missing return targets.

Sares-Regis is far from the only firm thinking about adjusting its return target. One placement agent told PERE opportunistic managers are also struggling to achieve their traditional targets – 20 percent IRR – and that mid-teen returns are now more realistic. However, only a “few” have reduced their targets to 18 percent or a range of 18-20 percent. He added that given the choice, more managers would lower their targets, but many investors are averse to a lot of change.

That is hard to understand given all of property’s return profiles have come in, and the fact that in a broader context, as fixed-income product yields move so must real estate yields, even those connected to the last rungs of the sector’s risk-return ladder.

The investors of Sares-Regis, for their part, appear to agree. They are understood to have shown substantial early support for Fund III – despite the lower return target.

They will have noted that returns have been coming down. Institutional real estate portfolios generated an average annual investment return of 8.6 percent in 2016, down from 11 percent in 2015 and the prior five-year average of 10.4 percent, according to the latest “Institutional Real Estate Allocations Monitor” report from Cornell University’s Baker Program in Real Estate and real estate advisory firm Hodes Weill & Associates.

While a lower return target may not seem favorable at first glance, both managers and investors will benefit if the former can put out capital more quickly into prudent investments rather than be bound by outdated and unrealistic targets from which both may be hurt by poorer performance. Sares-Regis’s fundraising progress, thus far, indicates there are some investors that agree.