LARGEST MANAGERS: Investors in real estate witness brighter returns

Tax-exempt U.S. institutional assets invested in real estate rose 32% to $275 billion in equity real estate at year-end 2005 from $208.4 billion in 2004 as returns began to brighten, according to Pensions & Investments' annual money manager survey.

Assets in real estate investment trusts also were on an upswing as of Dec. 31, rising 18% to $64.2 billion from $54.2 billion a year earlier, despite lower returns. REITs returned 12.2% for calendar 2005, down from 30.4% the year before, according to the National Association of Real Estate Investment Trusts, Washington.

By comparison, the 2005 equity real estate return was the highest since 1979. In 2005, equity real estate returned 20% vs. 14.5% in 2004, according to the NCREIF Property Index. (The return in 1979 was 20.5%.)

On a market-adjusted basis, real estate equity assets reported for the P&I survey increased 9.4%, and REITs grew 5.4%.

The top 25 managers accounted for the bulk of the assets under management in both equity real estate and REITs. The top 25 managers of internally managed equity real estate held $214 billion, 78% of assets. The top 25 REIT managers managed $60.9 billion, 95% of the total in this year's survey.

Mortgage-backed securities remained flat at $112.5 billion in 2005, after a 3% drop in 2004. High-yield manager assets were also close to 2004's totals, with $105.7 billion, up slightly from $104.9 billion. The Citigroup High Yield Market index returned 2.1% for 2005, down from 10.8% in 2004.

P&I's diminutive slice of the remaining alternative investment pie revealed that committed capital from institutional investors in private equity grew 14% to $22.8 billion, privately placed bonds dipped 2% to $50 billion and venture capital grew 9% to $15.3 billion. Distressed debt rose 66% to $12 billion, according to P&I's sample.

Last year was a banner fundraising year for venture capital and buyout fund managers. According to year-end 2005 data from Thomson Venture Economics and the National Venture Capital Association, venture capital funds raised $25.2 billion, up 48% from $17 billion raised in 2004. Buyout funds raised $89.2 billion, nearly double the $45.6 billion raised the previous year.

A number of factors converged in 2005 to make it a record fundraising year, said Michael Kelly, managing partner, Hamilton Lane Advisors LLC, Bala Cynwyd, Pa. Buyout firms began exiting investments in late 2003 and in 2004 after two tough years when they were neither fundraising nor returning capital to investors. Successful exits boost returns; returns rose as capital was returned to limited partners.

"Performance was good so limited partners were excited about it and firms were raising record-size funds," Mr. Kelly said.

While some venture capital firms appear to be showing some restraint in their fundraising, consultants say they are concerned with the massive amount of capital raised by buyout managers in 2005.

"We're pretty sanguine about venture capital," said Tom Lynch, managing director at Wilshire Associate's private markets group, Santa Monica, Calif. "In general, there's good balance."

Venture capital fund managers invested most of the funds they took in during the year, he said. Venture capital general partners have learned their lesson from when the technology bubble burst, drowning the returns of the 1999 and 2000 vintage year funds.

"In the post-2000 bubble era many venture capital funds are more cautious about how they finance and build companies," said Marc E. Sacks, senior managing director, private equity, for Mesirow Financial, a Chicago direct investment and fund of funds manager.

Buyout funds are not practicing similar restraint, they say. While it is not cataclysmic, buyout fund managers' fundraising universe is a mirror image of the venture capital world of 1999 and 2000, Mr. Lynch said.

"They are raising record-size funds, involved in bigger transactions for bigger multiples (higher prices) and taking on bigger risks," he said.

The risk-taking is evident in buyout club deals in which a group of buyout funds participate in a transaction. Buyout funds are exerting less control over the portfolio companies they are buying, which increases the risk, Mr. Lynch said.

"Our level of concern is up. We are more cautious about the buyout world today than we were in the past," he said.

What's more, there is a question whether buyout firms will be able to put all the committed capital to work.

"The shift in investment flows by certain hedge funds, BDCs (business development companies), others from public equities to private equity is a concern, because private equity is a small market by comparison — with a finite amount of great investment opportunities, " Mr. Sacks said.

A portion of the increase in real estate assets under management can be attributed to appreciation of real estate in general, said Michael McMenomy, global head of investor services at CB Richard Ellis Investors LLC, Los Angeles. (CB Richard Ellis Investors reported $7.26 billion in domestic equity real estate under internal management.)

"That is one element that has fueled assets under management," he said.

Another factor was an increase in capital flows into real estate, reflecting investor demand for the asset class, Mr. McMenomy said.

With REITs, returns were uneven in 2005, starting with -7.59% in the first quarter, then jumping to 13.52% in the second quarter, dropping to 1.94% in the third quarter and 1.26% in the fourth quarter.

REIT assets are rising as investors anticipate that earnings are on an upswing and are investing now to get ahead of the curve, said Joe Betlej, vice president and portfolio manager at Advantus Capital Management, St. Paul, Minn., which has $872 million in REITs under management, with $177 million of that from U.S. institutional tax-exempt clients.

Over the last several years, REITs have enjoyed improved access to capital, higher quality management team and improved systems providing better disclosure, Mr. Betlej. This all adds up to a better, less risky investment, he said.