STATESIDE: Opportunistic to the core

When it comes to institutional investors that have increased their core real estate allocation in recent years, there is no shortage of examples: the California Public Employees’ Retirement System (CalPERS), the California State Teachers’ Retirement System (CalSTRS), Allstate Investments, New Mexico State Investment Council and the Los Angeles Fire and Police Pensions, among others.  Indeed, the general consensus is that the vast majority of investors are weighting their real estate portfolios more heavily towards core as they focus more on stable long-term cash flow rather than shorter-term higher returns.

Many investors now are looking to pursue core strategies to meet their increased allocation targets, but they aren’t always reaching out to core real estate managers. Instead, a number of them are looking to tap those on the higher-risk, higher-return end of the investment spectrum.

The rationale behind hiring an opportunistic manager for a core strategy is to focus first on finding the best manager and then determine whether or not the manager can execute the strategy. In many cases, the investor already has a longstanding relationship with an opportunistic manager and prefers to have that firm oversee a core mandate, rather than bringing on a new core manager with whom they are less familiar.

An obvious question, however, is why an opportunistic manager would be interested in executing a core strategy, when the fee structure for core is substantially lower than the typical compensation for opportunistic investments. Although fee schedules can vary according to the investment, core funds generally collect 1 percent management fees on committed and invested capital, compared with 1.5 percent to 2 percent management fees for opportunistic vehicles.

One argument is that opportunistic managers may be willing to accept lower fees in exchange for a larger and more reliable overall fee stream in what can be a highly volatile market. They would do so by expanding their assets under management to include core investments, and this income would be in addition to the periodic incentive fees that managers collect from their opportunistic investments. This is certainly food for thought since some managers that focused exclusively on value-added or opportunistic strategies suffered during the downturn because those periodic fees didn’t always materialise.

Still, there’s no easy answer as to how to compensate opportunistic managers that are pursuing core strategies. As PERE understands it, some core investors now are trying to design compensation systems that would reward opportunistic managers for investments that produce ongoing, stable cash flow rather than a periodic influx of capital. Investors, however, need to be careful how they design such a compensation system because opportunistic managers otherwise may be driven to take greater risks in property selection and overall leverage than is appropriate for a core programme.

An opportunistic manager’s crossover into core also can be tricky in other ways. A manager certainly blurs the lines if it pursues “build-to-core” opportunities on behalf of a client, where the firm develops properties that will become core in the long term. CalSTRS, for example, is pursuing such as strategy with LCOR, a Berwyn, Pa.-based real estate investor and developer. The $153.7 billion pension plan announced in May that it had acquired a majority stake in the firm, with which it plans to develop and redevelop multifamily and commercial real estate assets in the Washington, DC to New York City corridor.

Driving build-to-core investments is the risk that investors run of overpaying for core assets, as a growing number of investors crowd into the core space and drive up prices for properties. Major institutional investors like CalSTRS are realising that they can’t achieve their core real estate allocation targets without expanding the definition of a core real estate investment. They’re willing to accept short-term development risk in exchange for avoiding the risk of overpaying for assets, while facing less competition and exerting more control over how their capital is invested than with a fund.

Moreover, an opportunistic manager executing a core strategy would most likely do so through a separate account relationship, which poses the question of whether or not the manager can build a separate account business as well as go into core real estate. A host of other issues also could be raised, such as whether or not separate teams would be assembled to focus on the core and opportunistic strategies and whether a separate account LP would carry more weight on certain issues than fund LPs. Another concern is what’s called “negative selection,” the perception that managers trying to expand into other areas are not successful in raising capital in their primary business.

Generally, the best-performing managers are thought to be those that pick one strategy and stick to it, rather than firms trying to be all things to all people. But, as one investor told PERE, “we are in the early stages of a significant fragmentation across strategies, given the existing turmoil and low-yield environment.” While opportunistic managers unlikely would be pursuing core real estate in a healthier market, it is a sign of the times – and a sign of what’s to come.