NCREIF’s Open End Diversified Core Equity index is set to post the largest single-year return in its history. The index, which formed in 1977 and serves as the benchmark for many institutional LP portfolios, has generated over 20 percent returns in 2021, PERE has learned. This represents a significant rebound from a 1.19 percent return in 2020.
However, many market participants – including consultants, managers and capital formation experts – are not sure the strong returns will continue beyond this year. Because of long-term fundamentals in core real estate, investors are wary about making new or follow-on commitments into ODCE funds, these sources said. Limited partners and consultants alike are taking a cautious approach despite the immediate injection of positivity from the returns.
There is historical precedent for returns continuing, Andrew Mitro, managing director at StepStone Group, said. Following the global financial crisis, strong double-digit returns continued for a number of years before normalizing, Mitro said.
Winners and losers
Within the ODCE index, there are clear winners and losers in terms of the main four property types. Industrial and multifamily have significantly outperformed, with TA Realty, a manager with a fund in the index, expecting industrial and multifamily to return around 35 percent and 20 percent respectively.
Meanwhile, retail and office values are stagnating because of flat or declining fundamentals, and more limited transaction volumes leading to lack of visibility in pricing, according to Taylor Mammen, CEO of RCLCO Fund Advisors. Q4 2021 projected returns for the two sectors were not available at press time, but Q3 2021 data showed annualized returns of 4.86 percent for office and 0.74 percent for retail.
John Sweeney, partner and chief operating officer at placement agent Park Madison Partners, noted the dispersion in sector returns is the highest it has been since 1977. This dispersion confirms the real estate market is changing, with the pandemic forcing the market to reconsider not only what should be considered an institutional property type, but also where and how each of them fall on the risk spectrum.
That tension is mirrored in the 2021 full-year results for NAREIT, with the public real estate indexes posting the second-highest ever yearly total return with 41.3 percent in 2021, around double that of the ODCE universe of funds. This discrepancy is mostly attributed to NAREIT’s investible universe containing around 40 percent alternative or traditionally “niche” property types, versus the ODCE’s 5 percent.
A question for investors to grapple with is to what degree ODCE may start to mirror public equity markets in terms of their allocations by property type, which would mean much higher allocations to niche property types, Mammen said.
Challenged asset classes
Because the ODCE index is mostly made up of the core four property types, with around 25 percent in industrial and 27 percent in multifamily, almost half of the index is in currently challenged asset classes – office, retail and hospitality, the latter of which makes up a significant portion of the other allocation. While retail’s struggles are well documented and have led to large write-downs in some ODCE funds, namely UBS’s Trumbull Property Fund, office values have yet to face the full brunt of the pandemic.
“Many observers suspect that these buildings may experience meaningful losses in the coming quarters as owners begin to sell and/or mark values to where buyers potentially would,” Mammen said.
This means manager selection is more important now. Six of the 27 ODCE funds included in the returns were formed after the GFC, meaning they have been able to capitalize on newer trends better than some of the older funds formed in the 1970s and 1980s.
The gap in performance between the ODCE equal weight and value weight indices is therefore growing, Mitro said, which can be attributed to manager decisions on portfolio construction by property type and a number of newer, smaller funds entering the index over the last few years that do not have legacy portfolios.
“Manager selection is so important. You cannot simply rely on beta exposure to real estate with the world changing as fast as it is. You need managers that can generate alpha within their respective property types,” Sweeney said.
The final difficulty facing ODCE funds when it comes to capital formation in 2022 is the range of options in the market. There are over 70 open-ended funds in the US, much more than pre-GFC, Mitro said. Moreover, a rise of targeted core-plus open-ended funds, separately managed accounts and non-traded REITs has meant investors have more choice than ever.
The outsize returns have benefitted those investors that committed to the ODCE index last year. Many of the market participants agreed that core and core-plus real estate are likely to receive significant attention from LPs this year and that ODCE is still an efficient way to place capital. However, they were uncertain whether core funds are the best options for future returns.