Real estate is next big thing in administration

Real estate fund administration might lag other alternatives back-office providers in terms of assets, but rising allocations in real estate and REITs by asset owners could send assets under administration in the sector skyrocketing in the near future.

Asset owners are driving much of the increase as they now pay greater attention to the cost and execution of internal operations vs. external administration for each manager.

“Institutional investors have due-diligence teams that review operations at their managers and also with (managers') key service providers,” said Tim Fitzgerald, director and global head of Deutsche Bank's alternative fund services, Boston. “One of the big questions investors ask relates to the administrator they've chosen.”

Currently, there are fewer administrators for real estate funds and fewer assets to administer compared to private equity or hedge fund administration. According to a survey by eVestment LLC, real estate assets under administration among the 13 providers surveyed totaled $203.8 billion as of Dec. 31, while hedge fund AUA among 41 firms surveyed totaled $3.79 trillion and private equity fund AUA among 28 firms surveyed was at $879 billion.

But while real estate AUA is far below other alternative asset classes, sources said third-party real estate administration has blossomed in the past two years — growing 9.6% in the second half of 2013, the first time eVestment has broken out real estate administration by firm in its alternative fund administration survey. The gain is a direct result of increases in real estate investments made by institutional asset owners, sources said, and AUA will continue to grow.

“Real estate seems to be taking the same path that large institutional money has been directed to before, like hedge funds and private equity, and administrators have grown to accommodate the demand for institutional-quality infrastructure those investors require,” said Peter Laurelli, vice president and head of research at eVestment, New York.

“The adoption of third-party administration has come around to real estate, almost in order: first hedge fund administration, then private equity administration, now real estate,” said Tim Donovan, senior managing director, head of real estate fund administration, North America, at State Street's alternative investment solutions group, Boston. State Street had $121 billion in real estate assets under administration as of Dec. 31, accounting for 60% of total real estate AUA in eVestment's survey.

Deutsche Bank's Mr. Fitzgerald said real estate fund administration historically had one of the lowest outsourcing rates compared with other alternatives. “In the past, core real estate has suffered from a return perspective, particularly in the U.S.,” he said. “In good days, the cost of international operations teams was less of an issue. Now, that cost is a material issue. (Managers) are now going through reviews of their operations.” Deutsche Bank had $4.05 billion in real estate AUA as of Dec. 31, up 35% from six months earlier, mostly from an existing financial institution client creating a new core real estate investment trust in Mexico. Mr. Fitzgerald wouldn't name the client.

Asset owners advised by Callan Associates LLC routinely ask prospective real estate managers about accounting operations, and while they don't generally decide based on whether the services are done in-house or by an external administrator, the issue does come down to expertise and cost, said Avery Robinson, San Francisco-based vice president and consultant in Callan's real assets consulting group.

“It's always a question we do ask,” Mr. Robinson said. “While we don't see a strong trend one way or the other (internal vs. external operations), it does come down to: One, how qualified are those doing the accounting, internally or externally? And two, what will the cost of these services be whether the manager does this or outsources?”

Messrs. Robinson and Donovan said an increase in the number of smaller real estate managers getting institutional assets has accounted for some of the AUA increase because those firms don't have the scale or capability of doing administration in-house.

However, Mr. Donovan said the cost of real estate managers creating an internal back office will be a future issue for asset owners seeking managers. Many of those asset owners could prefer that those firms use third-party real estate fund administrators instead. “Until you've built a back office, people don't realize what an enormous task it is, how expensive it is. You'd know why an investor would be concerned about this, about how a fund manager administers the assets.”

Still, asset owners now concentrate their manager search efforts on a firm's returns rather than their operations, but that is changing. “In such a newsy space like real estate,” because of its volatility, “there's a lot of news around it, so investors will spend more time on the returns. That's not necessarily unreasonable,” said Ian Toner, director of strategic research, Wurts & Associates, Seattle. “But the back-office components are going to get more and more important. Pension funds are not pounding the table yet about that, but we can see it growing in importance.”

While selecting a real estate fund administrator “is in the manager's court,” Mike Thompson, real estate portfolio manager at the $183.3 billion California State Teachers' Retirement System, West Sacramento, said prospective real estate managers are asked in the RFP process to disclose whether the back-office functions are performed internally or outsourced to a fund administrator, and if the latter, who that administrator is. “It's part of our overall due diligence. All of that matters; it's all part of selecting the right manager.”

One service that hedge fund and private equity fund administrators offer that real estate administrators don't, is valuation. Asset owners outsource that to independent third-party providers, who themselves are seeing a boom in business.

“Pension funds don't have a lot of resources to do this. At what point do you rely on the manager to do this? It's necessary especially to get consistency in valuing the holdings of multiple investment managers,” said Brian Velky, managing director, fiduciary and valuation services, Real Estate Research Corp., West Des Moines, Iowa. “It's not so much because of regulations ... it's more best practices. Pension funds believe it's in their best interest to get this data. They learned from the downturn (in 2008) why it's important.

“I tell clients that 10 to 15 years ago, appraisal and valuation were seen as necessary evils,” Mr. Velky said. “But today, there's so much more they offer in terms of risk management. You can understand where your exposures (in real estate) are. Is your real estate allocation where you want it to be? How do you know how different managers' portfolios are performing? How can you move your portfolio to adapt?”

Current RERC clients include CalSTRS and the $177.9 billion Florida State Board of Administration, Tallahassee, which hired the firm earlier this year.

Florida had performed valuation in-house prior to hiring RERC, said Dennis MacKee, FSBA spokesman. The change was made because oversight of valuation was re-assigned last year to the FSBA's accounting department from its investments department. “That move led us to the determination that we need a third party to value our real estate assets, to do so in a most effective, cost-efficient way,” he said.

Third-party valuation “is a trend in the industry,” said CalSTRS' Mr. Thompson. “This is important because our real estate investment policy calls for us to use industry best practices. A third-party firm allows us to do that independently, providing guidance on best practices and helping us write a valuation policy and process which we all follow.”