STATESIDE: Getting ready for a dislocation

The private real estate industry has been talking about an imminent correction for a number of years now. But one sign that makes some investors believe a dislocation will happen sooner rather than later can be seen with the National Council of Real Estate Investment Fiduciaries’ Open End Diversified Core Equity index, which comprises 24 US core funds totaling $211.7 billion of gross real estate assets.

Since the third quarter of 2015, the volume of quarterly redemptions has nearly tripled, from $1.6 billion to $4.6 billion during the second quarter – the most recent figures available at press time. Also, for the first time since 2010, some of the largest ODCE funds have been seeing exit queues this year – JPMorgan Asset Management’s Strategic Property Fund reported a redemption queue of $688 million at the end of the Q2, although the firm told PERE that it had cleared the queue as of the end of Q3.

To be sure, net flows – the difference between contributions and redemptions – into the ODCE funds continue to be positive, with $594.2 million recorded during the second quarter. Indeed, foreign investors are said to have shown increasing interest in the ODCE funds, now that entry queues – which once stretched to 18 months – have shortened considerably. Also, US pension plans such as the Oregon Public Employees Retirement Fund and Alaska’s retirement systems are shifting significant capital out of real estate investment trusts and into ODCE funds. Nevertheless, net flows are at their lowest levels since the third quarter of 2013, when they stood at $242 million.

The uptick in redemption activity is happening for multiple reasons. Real estate has been one of the best-performing asset classes for many institutions and some are taking profits off the table, while others are rebalancing their portfolios as the strong numbers have made some investors over-allocated to the asset class. In other cases, investors have too much money concentrated with one or two managers and want to better diversify.

Perhaps most noteworthy, however, multiple industry insiders cited nervousness about core pricing – and, by extension, concerns about the overall real estate market – as a major reason why some are pulling money out of the ODCE funds.

One source who has raised money for a large core fund said investors are making redemption requests now because they learned the hard way during the last downturn, when they made requests too late in the cycle and got stuck in long exit queues. In their view, pricey core valuations point to the real estate market moving closer to a dislocation, so they are being proactive.

Thomas Wels, global head of real estate at UBS Asset Management, had a different take, with redemptions being a trigger, rather than a symptom, of a potential correction. He told PERE that some investors are making redemption requests to move capital to higher-risk strategies, because given their return expectations, core funds can no longer deliver. Such institutions, in his view, could consequently make risky investment decisions by increasing exposure to higher-risk strategies at the wrong point in the cycle. Such behavior, he feared, could spell “the beginning of a potential catastrophe.”

Wels may not have as much reason to fear as he believes. One advisory firm said, anecdotally, investors withdrawing capital from the ODCE funds are overwhelmingly using that capital to create separate accounts – where they have much more control over an exit – or to invest in what they perceive to be more defensive or less economically cyclical strategies such as real estate credit, medical office, student housing and self-storage.

Given this investor caution, even if a market dislocation does occur in the near future, it is unlikely to be the global financial crisis-like catastrophe that some people may fear. This time around, many more investors are trying to be better prepared, because they simply do not want to get stuck again.