Eric Lang, senior managing director of external private markets at the Teacher Retirement System of Texas describes his organization as in the “milk, bread and eggs” business, responsible as it is for putting groceries on the tables of retired educators in the US state by managing a trust fund of $140 billion. Some 14 percent of that sum is invested in real assets, a division managed by senior director Grant Walker. Eric Wurtzebach, senior managing director at Macquarie Capital, invites the TRS pair to deliberate on how to achieve the best outcome for the scheme’s beneficiaries despite the current highly competitive market conditions.
Balancing a portfolio in a mature market
Eric Wurtzebach: Where do you think the market is in terms of the ball game analogy? What inning are we in?
Eric Lang: We have been asking that question for years. It feels like extra innings. However, as the famous Chicago Cub Ernie Banks used to say: “Let’s play two.” Real estate fundamentals are healthy. However, capital markets are fairly or fully valued and there is a lot of money chasing deals, so that gives us pause. If pension funds do not underwrite as if we are in the later stages of a cycle then we are doing our members a disservice. Especially in private markets most asset classes are mature and fully valued. Grant, how about you explain our style of investing.
Grant Walker: In real estate, our different risk bucket targets are 40
percent to core, 12.5 percent to value-add and 35 percent to opportunistic, with the remaining 12.5 percent to special situations. For core we are not at that target right now, we are at 36 percent, and we are higher than our target on value-add. That is based on where we think the opportunities are and where we are in the cycle. Recently we have started to do a develop-to-core strategy. We can get a yield premium from development and then transfer assets to our core portfolio to hold them long term, rather than paying low cap-rates for existing stock.
EW: Given where we are in the cycle, is develop-to-core an increasingly attractive strategy because it decreases the challenge of re-investing proceeds at a lower return? Is it better to hold longer-term these days?
EL: That is the hardest question we ask each other every day. Every day we hold an asset is a decision not to sell. We sell assets if we think the market is giving us a price significantly above the fair value of the asset. We do not hold if someone is willing to pay us above what we think is full value.
EW: Core assets in core markets seem fully priced today. Does that make secondary and tertiary investments more desirable? And how about specialty asset classes? Is there more value today in asset classes outside the four major food groups?
EL: Wow Eric, there are lots of things to think about with those questions. The thing that keeps us up at night is how do we re-invest capital in today’s market. The majority of our real estate investments are through commingled funds, so we are constantly having to recycle capital when we get distributions back. We have not done much core in the gateway markets because we see those as fully priced. Even in niche property types like student and senior housing, medical office and self-storage there is so much capital chasing deals that it is becoming difficult to find opportunities, but we are always looking for assets there that may offer outsized returns.
We are value investors. We look for assets that might be incorrectly valued, might not be as attractive to other investors, or where there is something to be fixed that might add value. We don’t mind taking risk as long as we understand what the risks are, can underwrite them, and can get paid for them. We have to be willing to search around for value, which sometimes takes a lot of time.
“We don’t have to do every good deal we see, we just have to avoid the bad ones”
– Grant Walker
GW: We invest in core properties in markets that some might consider secondary, but we do not. Cities like Nashville, Denver and Austin. We like to invest where population and jobs are growing. We find those assets have more income growth than a typical core gateway asset. We never bet on cap rate compression. We would rather bet on income growth and occupancy. We don’t have to do every good deal we see, we just have to avoid the bad ones. Because we are near the top of the market it is important to avoid taking on too much risk and doing one deal that really has a negative impact.
Managing relationships with managers and operators
EL: We want every relationship with a manager to be of scale. That is typically $500 million if not $1 billion. Performance, track record and the breadth of the manager are very important. Can they do more than one thing? Cover different styles? Or different property types and geographies? If we can have a relationship that covers us across our whole portfolio that is always a plus, although there are still some very good specialists out there as well. We need complete transparency with our partners, an open dialogue about what is going on with the assets, good and bad. I always say to our managers: “We have 40 of you guys across the globe, so we have probably seen what you’re going through somewhere else. You can use us LPs as a sounding board or a no-cost advisor to give you suggestions.”
We understand that when the market goes against us it is not necessarily the manager’s fault. If an investment decision didn’t go our way then that’s fine, but let’s see if we can solve that issue together. We also value partnership and we value proper reporting. We have developed some cool data analysis technology and managers that do not comply with our reporting needs will not be our managers going forward. We are big supporters of the NCREIF/PREA reporting standards including standards for closed-end fund reporting.
GW: The other thing that we focus on with our managers is alignment, and fees are obviously a big point there. We don’t want to pay above-market fees, we want to pay fair fees that compensate them for the work they do. They should make money when we make money, such as when their investment vehicle’s performance exceeds the target return or benchmark and the manager becomes eligible for a promote or incentive fee.
EW: Since the financial crisis a lot of your peers in the US talk have been talking about lowering the total number of managers they have. Do you currently have the right number of managers? Or are you actively lowering the number?
GW: There are 40-45 on a go-forward basis that we would potentially be making new commitments to. If anything, that has reduced over time. At one point we probably had more like 55 managers. We have limited resources on our team to manage relationships. We are not looking to reduce the list further at this time, but we are also not looking to add to it.
EW: Given how much capital is available today for good sponsors, do you feel you are chasing good operators as much as they are chasing you? Do you have to make sure you are a good partner for operators?
EL: All money is green, so they want to make sure that whoever is funding them is going to be a good partner. Our managers and operating partners underwrite pension funds and other capital providers just as much as we underwrite them. That is one of the reasons why we opened an office in London. Our team there gets to know our partners in Europe and they get to know us. Boots on the ground are important. If you don’t dedicate resources to outreach you are missing the boat.