We at PERE hear it all the time: a relatively conservative institutional investor that targets primarily core real estate domestically or regionally decides to expand internationally. In doing so, the investor targets higher-risk strategies in its selected overseas markets than it does for its home market.
Intuitively, this would seem to be backwards, and several managers and consultants to whom I mentioned it during PERE’s Global Investor Forum in Los Angeles at the end of April chuckled knowingly in amusement. Was I missing something, or are a number of smart, sophisticated institutions investing in the face of common sense?
Granted, I am no expert at portfolio management, so there very well may be some legitimate reason or reasons for structuring a real estate portfolio in this manner. Still, most of the reasons I’ve heard sound more like rationalizations or excuses than true rationales.
For example, a common reason given for targeting higher-risk strategies overseas is that the institutional investor in question requires the higher return to offset any country or regional risk. I completely understand the need/desire to receive a return premium for investing in foreign markets, particularly developing ones. However, moving up the risk spectrum doesn’t achieve that return premium, it just compounds the risk.
Any return premium should be visible in the market’s most stable core assets. If it isn’t, then the market does not offer a return premium on its real estate. Either the investor can accept that or it should look at another market in which to invest. Adding strategy risk on top of market risk only serves to make the investment twice as risky.
Another common reason given for targeting higher-risk strategies overseas is that there are not enough core options available in a given market/region. That may be true in some of the more emerging markets, such as some of the Latin American markets outside Brazil or certain markets in Eastern Europe and Southeast Asia. For everywhere else, however, that may have been true before, but not so much anymore.
Take Asia, for example. Since the global financial crisis, a number of institutional investors have been looking to diversify their real estate portfolios into the region, primarily to take advantage of China’s growth story. Of course, these investors realize that China is a growth market with corresponding risks, so they have opted to invest in pan-regional vehicles, almost all of which have been value-added or opportunistic in nature – until recently, that is.
With the emergence of core funds in Asia, investors targeting the region no longer need to go up the risk spectrum in order to get exposure. Indeed, there now exist several core options from reputable fund managers, both global and local, from which to choose. As a result, the excuse that core options do not exist in the region is no longer true.
While there are examples of institutional investors around the world engaging in such counterintuitive investing, the biggest group of perpetrators appears to be public US pension plans. Indeed, several examples spring to mind. However, rather than call out each one, let me instead use their role model and America’s largest public pension plan, the California Public Employees Retirement System (CalPERS), as an example.
Since the crisis, CalPERS has made no secret of its plans to move the bulk of its massive real estate portfolio into core strategies. In fact, it has a long-term strategic target of 75 percent to 100 percent of its real estate portfolio in core strategies by July 2017, up significantly from its current level of roughly 50 percent.
Meanwhile, CalPERS also has been diversifying its portfolio internationally, particularly in Asia. Interestingly, a number of those investments have been more higher-risk in nature. Indeed, its investments with ARA Asset Management spring to mind. Meanwhile, the region currently offers a number of core options, any number of which would help the jumbo pension plan to achieve its lofty core allocation target.
On the other end of the spectrum, the group of investors that most often seems to avoid such counterintuitive investing is Asia institutions. Of course, one could argue that going international for that group typically mean investing in the US and the UK, arguably the two largest core property markets in the world. However, even when they move beyond those markets, they typically stick to a core strategy abroad. For that reason, they should serve as role models to other conservative investors on how to invest in overseas real estate.
Of course, if you are an institution that targets primarily higher-risk strategies or a mix of strategies regardless of region, much of this argument holds little interest to you. However, for those institutions targeting core property domestically and higher-risk real estate internationally, it seems that the smarter strategy would be to do just the opposite.
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