Compatibility tests are most commonly associated with dating and romance as assessment tools of how suitable two people are for each other. Apparently, the private equity real estate world has compatibility tests of its own.
The most recent real estate performance measurement report for the Los Angeles County Employees’ Retirement Association (LACERA) is a case in point. In it, the pension system examines how well different risk strategies meshed with a separate account structure.
Like many large real estate investors, LACERA increasingly has invested capital through separate accounts because of greater controls, more favourable fees and potential liquidity. In fact, 88 percent of the $39.2 billion pension plan’s real estate assets are held in such vehicles.
Moreover, all of LACERA’s core investments, which account for 63 percent of its $4.36 billion real estate portfolio, are held in individually managed accounts (IMA). The pension system established its first core IMA programme in 1991 and has since hired 10 managers for various core separate account mandates.
Although a few mandates have underperformed, the core real estate separate accounts overall have achieved a return of 9.2 percent since inception, which exceeds the NCREIF Property Index benchmark return of 7.4 percent for that period. LACERA’s non-core real estate portfolio, by contrast, delivered a return of -9.7 percent since inception, according to the report, which was prepared by real estate consultant The Townsend Group.
One of the challenges associated with the non-core portfolio related to investing through separate accounts, which hold 81 percent of LACERA’s value-added investments and 39 percent of its opportunistic assets. “While IMAs provide greater investor controls, there are unintended consequences in utilizing long-term vehicles in shorter-term strategies (value and high return),” the report stated.
Shorter-term strategies typically involve a J-curve, with negative returns generated in the early years of the investment period and positive returns in the later years as property values are realized. In a closed-end commingled fund, this J-curve only occurs once because all of the capital is allocated at the beginning of, or prior to, the investment period. In a separate account, however, continual capital allocations are made over time, which results in multiple J-curves that could be a potential drag on the vehicle’s overall returns.
In addition, properties remain in the separate account’s portfolio during development or rehabilitation, but exit once they are completed or stabilised. As a result, there could be periods of time where no assets are held in the vehicle, or high-return assets are sold and low-return assets remain. This may lead to more periods of negative or zero returns in a non-core separate account than positive returns resulting from value appreciation. This also could distort the performance of the individual manager or the non-core components of the real estate portfolio, depending on the size and duration of the IMA vehicle.
The solution to multiple J-curves and zero percent quarters is to treat the separate accounts more like closed-end funds, where capital allocations would be separated out by vintage year and strategy and measured using IRR versus time-weighted returns. This essentially creates a separate account “series” similar to a traditional commingled fund series, which would make it easier to evaluate manager performance. In fact, some investors already have designated separate accounts to be “limited-life vehicles,” while some managers informally “bucket” the various allocations within a separate account by year and strategy.
Making separate accounts more like closed-end funds, however, raises the question whether it simply makes more sense to invest in commingled funds when pursuing non-core strategies. Funds, after all, are the preferred method of investing in value-added and opportunistic real estate. However, the decision may have less to do with returns or the J-curve effect than with how incentive compensation is calculated.
In open-ended separate accounts, incentive fees are paid out every three years and are determined by property appraisals, which can be difficult to do if the asset is not stabilised and not producing cash flow. This is in contrast with the incentive structure for closed-end vehicles, which are based on cash proceeds from property sales.
That said, investors with the scale to set up separate accounts may still prefer to do non-core investing through these structures not only because of the increased controls and better fees, but also because of greater flexibility in how long they can hold assets.
Ultimately, there isn’t one right way to invest in value-added and opportunistic real estate. If the investor’s goal is to hold assets and generate steady income over a long-term period, then an open-ended separate account may be the right choice. However, if the investor is more interested in a quicker repositioning strategy, then a closed-ended vehicle may be more appropriate.
So, while it can seem like non-core real estate investing and separate accounts make odd bedfellows, in many cases, it’s still a relationship worth saving.