HOT STORY: Opportunists crowd the house

Starwood Capital Group is going into 2017 with a new business line: core-plus real estate. The Greenwich, Connecticut-based private investment firm kicked off its new platform with the formation of a $300 million separate account with the Teacher Retirement System of Illinois, targeting investments in diversified property types globally, as revealed by PERE.

With its new business, Starwood becomes the latest traditionally opportunistic private equity real estate firm to pursue lower-risk, lower-return real estate investments. It joins an increasingly crowded marketplace including heavyweight contemporaries Blackstone and Brookfield Asset Management.

To date, the success of new managers in the core-plus space has been “mixed and somewhat divergent,” said Christopher Rice-Shepherd, managing director at alternatives advisory services firm Cliffwater. Some public pensions have made significant allocations to core-plus real estate, given the income generation and long-term appreciation associated with such funds. Other investors, however, have shied away from core-plus real estate as they expect depreciation in property values in the near term and are waiting for a more distressed cycle where more opportunistic investments could once again provide strong risk-adjusted returns.

That said, there has been an overall increase in core-plus fundraising on an absolute basis. “We’re spending more time and committing more to core-plus than we ever have,” said Rice-Shepherd. “I expect commitments to continue to increase for the remainder of the year.”

One of the reasons that managers have been flocking to core-plus is investor concern about a late-stage real estate cycle. “Values and cap rates are at an all-time high in the top five gateway cities,” said Mark Grinis, global real estate fund services leader at professional advisory services firm EY. “Because you can get a little bit more yield and still high quality assets, core-plus is attractive.”

In many cases, investors have turned to their traditionally opportunistic managers to source core-plus investments because of those firms’ prior successes in higher-risk, higher-return strategies, while also seeking to reduce the number of manager relationships. “Once they’re happy and have gotten comfortable, it’s allowed us to raise greater amounts of capital from them,” said one general partner who wished to remain anonymous.

But managers that are new to the space may still need to prove themselves. Starwood’s launch via the formation of a separate account, for example, was viewed by some as a natural precursor to raising a commingled fund. Firms such as Blackstone, after all, similarly formed separate accounts to make initial core-plus investments before launching funds.

Too much capital
In fact, “the overall assessment is that opportunistic managers that have ventured into the space have had much more trouble raising capital than either they or I would have expected,” said Rice-Shepherd. “It’s pretty muted.”

That is partly because of the makeup of the target investor pool for the new wave of core-plus funds, which includes investors seeking an alternative to core or value-added strategies. “At this stage of the market cycle, there are more value-add and opportunistic investors that are seeking a bit more safety than core investors that are willing to take additional risk,” he explained. “But the core universe is simply a much larger one.”

At the same time, managers just starting to raise open-ended core-plus funds may also have to vie against funds on the National Council of Real Estate Investment Fiduciaries’ Open End Diversified Core Equity index for investor capital. “The barriers to open-ended funds are more challenging,” noted Grinis. “Managers must be able to answer, ‘What is the value proposition when compared to existing ODCE indexed funds?’”

In some ways, it is still easier to raise opportunistic capital, given the closed-ended structure of opportunistic funds compared with the open-ended nature of most core-plus funds. “With open-ended funds, there’s not that urgency [for investors] to make a decision,” said another manager.

Additionally, core-plus fundraising has become more difficult in a more crowded playing field. “As more managers move into the space, it becomes more of a challenge to differentiate yourself from the competition,” said one placement agent who has helped to raise both core-plus and opportunistic funds.

“With core-plus, you’re buying relatively stable assets, typically located in major markets. So how does one manager differentiate itself from another manager pursuing the same assets in the same markets? Whereas in the value-add and opportunistic space, a manager can more easily demonstrate what makes its team special – the team’s vision, its capabilities, how it creates value through skilled sourcing, underwriting and asset management, how it sees value where others do not. It’s much harder to differentiate in core-plus when so much of the execution is the same across managers.”

The bigger concern, however, is the potentially destabilizing impact of having so much capital chasing core-plus investments. “If too much capital is raised in core-plus and there’s not enough opportunities in the space, there may be risk,” the placement agent said. “When so much capital is raised and has to be put to work, that’s when you see managers go into deals they shouldn’t have.”
For example, if a manager has trouble sourcing core-plus deals that meet its return objectives, it might end up chasing more core-like deals that could underperform or more value-add-like deals with too much risk.

Opportunistic managers that have expanded into core-plus also need to be careful that these new vehicles do not take away from longer standing, more successful opportunistic businesses, said Rice-Shepherd. “It’s hard to make the case for both strategies,” he noted. “Cannibalization is a greater risk than these managers realize. I would have trouble defending both strategies from a single manager to my investment committee.”

Investing in both strategies potentially makes sense for smaller real estate investors that may be looking for strategy diversification and a desire to maintain a limited set of managers in their portfolios, Rice-Shepherd said. But all investors should consider the strength of sourcing networks, the depth of operating partner relationships and potential investment conflicts that could arise from investing in a manager’s dueling platforms, he added.

Indeed, while some traditionally opportunistic firms have found success with new core-plus real estate strategies, having both businesses is not necessarily easy for every manager to juggle, a factor that will only become more complicated the more crowded the core marketplace becomes.