Investors climbing risk ladder again to enhance returns

Institutions are again investing in the riskiest real estate as they search for returns, after having moved into more stable, cash-flowing assets following the financial crisis.

Some 55% of all real estate funds raised this year through June 23 are opportunistic funds, up from 32% in all of 2014, according to London-based alternative investment research firm Preqin. So far this year, 10 U.S.-focused opportunistic funds raised $24.9 billion, up from 37 funds that raised $10.5 billion in all of last year, while 18 global opportunistic real estate funds raised $32 billion in the first half of 2015, up from 69 global funds that raised $33.1 billion in all of 2014.

Investors are moving into opportunistic and value-added investment vehicles, which make riskier transactions in land, unoccupied buildings or in smaller cities or developing countries. Core investments concentrate on stable, cash-flowing properties in major cities.

Because investors are running out of higher-quality real estate options, they are looking at properties that need some work before providing cash flow.

“Core properties are very scarce and in very scarce supply,” said Ronald Dickerman, president of New York-based real estate money management firm Madison International Realty LLC.

Buyers are starting to accept lower returns for the stable, income-producing core real estate holdings.

“It's the greater fool theory,” Mr. Dickerman said. “Rates of return are being squeezed to single digits.”

There is a general movement to higher-risk core, said Ken Riggs, president, Situs RERC, a real estate research firm in Des Moines, Iowa. Investors also are going beyond core into niche real estate such as student housing and senior housing, he said.

After the financial crisis, there was a flight to core real estate, said Jamie Sunday, Boston-based partner in the real estate group of Landmark Partners, a private equity and real estate investment company specializing in secondary funds.

“Many institutional investors have traditionally been heavily weighted with core exposure,” Mr. Sunday said. “However, as risk profiles have evolved, we see more focusing on value-add and opportunistic funds to find higher returns.”

Investors are so eager to invest in opportunistic funds that The Blackstone Group and Lone Star Funds were able to have single closings on huge opportunity and debt real estate funds earlier this year. Blackstone closed its $14.5 billion Blackstone Real Estate Partners VIII in March and Lone Star closed the $5.5 billion Lone Star Real Estate Fund II in April, Preqin data showed.

A survey by San Francisco investment bank Probitas Partners in April showed that for most institutional investors, opportunistic and value-added real estate funds are key targets for their portfolios this year.

New Mexico State Investment Council, Santa Fe, which oversees $20.5 billion in endowment assets, has been “active in looking for investment opportunities beyond core,” said Charles Wollmann, director, communications and legislative affairs.

Five years ago its $1.3 billion real estate portfolio was entirely opportunistic, favoring riskier real estate bets made with partners in funds and joint ventures, he said.

“We're still working through our legacy assets,” he said, adding the council is not interested now in joint ventures.

The council's real estate allocation target ranges from 40% to 70% core and 30% to 60% non-core. The current breakdown is 60% of invested capital in core real estate and 40% in non-core, he said.

The New Mexico fund also is an example of investors going into riskier assets, even within core. On June 23, the council made its first commitment to an international real estate fund, Mr. Wollmann said, moving $150 million to the Invesco Asia Real Estate Fund, an open-end real estate fund that the council considers a core investment.

And within core, investors also are taking more development risk.

Even an ostensibly core building such as Chicago's iconic Willis Tower — formerly known as the Sears Tower — needs further improvements in the form of repairs, new tourist attractions, and new office and retail tenants. In March, Blackstone Group's Blackstone Real Estate Partners VII announced it was buying the tower for $1.3 billion.

“It's really a development project,” Mr. Riggs noted. “It will have to be retenanted and so there is risk going forward that Blackstone is taking.”

Taking on more risk makes sense, he said, because riskier real estate that offers a chance of rising rents provides a better hedge during times of rising interest rates, Mr. Riggs said. Core real estate does not provide as good of a hedge because the rents are fixed.

Other observers are mixed on this point.

Leo Huang, senior portfolio manager and head of commercial real estate debt at Greenwich, Conn.-based hedge fund firm Ellington Management Group LLC thinks “we are at a risky part of the real estate cycle, in which rates have gone up some and could go up more.”

Leverage is high, valuations are frothy and capital to buy real estate is abundant, he said. “It's not an environment where you should be backing up the truck to add risk,” Mr. Huang said.

But Jeff Saltzman, managing director for alternative business development for AllianceBernstein LP, New York, said it is the riskier, opportunistic or value-added real estate that promises to offer a source of uncorrelated return.

On June 19, AllianceBernstein closed its second opportunistic real estate fund, the $1.2 billion Alliance Bernstein U.S. Real Estate Partners II, above its $1 billion target after just nine months. The fund has a broad global mandate allowing it to invest in everything from land and hospitality holdings to multifamily and office properties, Mr. Saltzman said.

Its broad mandate is a diversifier that AllianceBernstein executives expect will reduce risk while offering investors higher returns than stable real estate portfolios, he said.

The new fund is backed by a global mix of investors, with one-third sovereign wealth funds plus pension funds, endowments and foundations, he said.