FEATURE: Health check

Be it fixed income, global equities or even mainstream private equity, most investment classes are in “recovery mode” if you listen to the multi-billion-dollar retirement systems delivering results for the 2009/2010 fiscal year. But the bad news is that real estate appears to be the exception.

PERE decided to take a look at a selection of investors to see how they are faring, and also whether negative returns mean opportunity funds are destined for the morgue.

The performance of opportunistic vehicles within the portfolio of LPs highlighted here range from sickly to near-death. Yet the responses to that are quite similar. While some opportunity fund managers are being let go, and core property investing is coming to the fore, there is also appetite to select opportunity fund managers that LPs feel confident in because they want to take advantage of distress.  

At press time, LPs were not necessarily reading the last rites of opportunity funds, but treating the bad ones like weak organs that need to be replaced with stronger versions.     

The European heavyweight

Denmark-based ATP Real Estate has not exactly enjoyed stellar returns lately from the 27 private equity real estate funds it has invested in. According to the division, it suffered a -17.9 percent return in 2009. Yet the strategy is still focused on private equity real estate funds and joint ventures in the US and Europe – both higher risk and core, so it has not turned its back on the sector. It is noteworthy that given the current debate about falling returns for private equity real estate, it has an overall expected internal rate of return from its current investment programme of 9 percent to 11 percent. It says it is investing in the main commercial property assets in the US and Europe, but it draws the line at emerging markets or pure debt strategies.

The US giants, Part I

“The positive returns over the last year are due to many factors, including the stabilisation in the financial industry and the increase in market liquidity,” said Joe Dear, CalPERS chief investment officer as he spoke about the California pensions’ 2009/2010 fiscal year results. “Many asset classes have exhibited strength amid signs of stabilisation and recovery in the economy.”

Good so far, but then you can almost hear the needle scratch the record as the next words uttered were: “With the exception of real estate.”

It turns out that real estate has been a drag on all other asset classes which had positive returns for the year and which Dear described as “definitely in the recovery mode”.

Much of the finger of blame can be pointed at opportunistic funds. Against a benchmark of NCREIF’s property index NPI + 400bps, it was 37.7 percent down in the year. Real estate declines reflected write-offs and deleveraging a portfolio that relied too heavily on borrowing at the peak of the bubble in 2005 and 2006, CalPERS admitted. No wonder Dear added: “We’re moving back into core properties and accepting managers in whom we have confidence. We’re letting go underperforming managers and looking for the best possible deals as they become available in a still sluggish market.” It has reportedly saved $100 million in fee reductions by renegotiating agreements with some private equity and private equity real estate funds.

The US giants, Part II

The California State Teachers’ Retirement System saw everything improve in the year to 2010. Everything that is, except real estate. Embarrassingly for those that recommended investments and for the funds involved, CalSTRS’ returns for global equities, fixed income and even private equity were positive, but real estate was -12.4 percent. Yet this isn’t the end for CalSTRS relationship with property. It said in July this year it would temporarily shift 5 percent of its global portfolio from global equities to fixed income, private equity, and yes, real estate. This is to take advantage of the “distressed market”. But the shift will see more going to core and less to value-added and opportunistic vehicles. Allocation to the latter will diminish from around 65 percent to 30 percent.

Performance of real estate does seem to be improving in 2010. Its portfolio showed “moderate signs of economic recovery” and “stabilisation”, according to a semi-annual performance review presented in April by investment adviser, The Townsend Group. However, Townsend said investments relying heavily on leverage to meet target returns had not fared as well in the market decline and continued to negatively impact portfolio performance. Many of the opportunity funds it has invested in are showing large negative IRRs. Of the international ones, the worst are MSREF VI International 2007 (-68%), MGPA Asia Fund III 2007 (-66.5 percent), and Redwood Grove JV 2007 (-60.1%).

What CalSTRS is now doing is reclassifying its portfolio into core, value added and “high return” rather than the somewhat confusing “tactical” classification that opportunity funds and international funds are currently lumped in with. At least CalSTRS has the consolation of knowing that though bad, its high return portfolio beat the NCREIF-Townsend Opportunistic Index which was -15 percent.

The Irish LP

Ireland’s National Pensions Reserve Fund saw its investments in private equity real estate perform worse than its listed real estate securities, but this says more about public markets than anything else. According to the published annual report for 2009, the fund says equity markets globally began to anticipate economic recovery – this explains the relative better performance of listed real estate over its investments in real estate funds, several of which are opportunistic. But basically 2009 was a year to forget with all property investments returning a disappointing -33 percent.

By way of contrast, the Pensions Reserve Fund’s investment in mainstream private equity investments managed 7 percent, so unlisted real estate appears to be faring worse. 

Yet the pension fund is not turned off from private equity real estate.

It says there are now signs of stabilisation and attractive opportunities are gradually emerging in selected markets.

In January, Brendan O’Regan, who has responsibility for property, told a PERE roundtable debate: “Investors are again focused on the benefits that real estate can offer, such as diversification and attractive risk adjusted returns, underpinned by income. These attractions can now be found at the lower risk-return end of the scale by investing in core/core-plus. If we see a faster and more robust economic recovery, well, the returns will be even better.”

The Australian kid

Australia’s new Future Fund began making investments in private equity real estate from July 2007 – a dangerous time given that Lehman Brothers collapsed the next year. This is the vintage that has produced a bad crop of performance. The fund doesn’t break down performance for property, but the key point to note is that whatever the short term decline it may have suffered, it will be making more long term investments. This is an example of a fund set up by a government a bit like Ireland’s National Pensions Reserve Fund to meet future obligations.

It has already increased its holdings in real estate from A$529 million in 2009 to A$2.5 billion. One firm familiar with the fund told PERE in this year that the Future Fund was still seeking to make commitments to blind pools of capital, calling the Fund “opportune led”. That said, it may have been concentrating on domestic real estate recently. “They have the capacity, the intelligence and the approval systems in place to make global investments, but I think at the moment they are focused on Australia,” according to the source. Overall, it seems to be in a strong position. Performance of all its investments – including property – increased 11.8 percent in the nine months to 31 March, 2010.