Core real estate managers adding a little risk to portfolios to bolster returns

Core real estate isn't what it used to be — it's a bit riskier.

Investors expect core funds to be portfolios of very stable, low-risk real estate, but core properties have become very expensive. So managers are taking advantage of provisions in their fund documents allowing them to add riskier investments, including development and buildings with higher vacancies, to their core portfolios.

Most investors allow core managers to invest a portion of their capital in non-core investments, but the percentage of non-core assets in core accounts has skyrocketed.

“There's been a threefold increase in U.S. funds in terms of development,” between 2011 and the second quarter of 2015, said Peter Hobbs, managing director and head of real estate research in the London office of MSCI Inc. “It happens at this stage of the cycle. We look for behavior that will haunt people, and this is one.”

The absolute level of rolling quarterly development expenditure in open-end core funds grew to more than $1.7 billion starting in the fourth quarter of 2014 from $297 million in the fourth quarter of 2011, and $1.8 billion in the second quarter of 2015, according to MSCI data for funds in the PREA/IPD U.S. Property Fund index. As a percentage of total fund value, investment in development has doubled to 8% in the second quarter from 4% in 2011 due to the increasing value of the overall index.

Another investment practice that might come back to haunt managers and investors is the addition of other non-traditional property types, such as self-storage, “because core property types aren't doing well,” Mr. Hobbs said. For example, exposure by dollar amount to self-storage by core funds in the PREA/IPD U.S. Property Fund index more than doubled to $3.4 billion in the second quarter of 2015 from the second quarter of 2011. Self-storage made up 2% of total core fund value in the second quarter, up from 1.53% in the second quarter of 2011.

Core real estate managers acknowledge the slice of their portfolios invested in non-core has been increasing lately.

“We do have a sliver of allocation to non-core type projects,” said Eric Adler, London-based managing director and CEO of Prudential Real Estate Investors. “Investors are happy to see us do that within the mandate. For a while, we were underallocated (to non-core) … but we've definitely moved up in the last 12 to 18 months.”

David Gilbert, president, chief investment officer and head of acquisitions at New York real estate manager Clarion Partners LLC, said core funds always have invested in non-core.

“Virtually all of the … (funds in NCREIF's open-end index) have allocations of up to 10% for value-add investing, which makes a lot of sense,” Mr. Gilbert said. “What we and others do in that bucket is create core, not with a desire to flip but to hold it. Open-end funds have done it forever. The amount varies from zero to 10%.”

To be included in the NCREIF Fund Index Open End Diversified Core Equity index, funds have to have at least 80% of total assets invested in core properties, said Sara Rutledge, NCREIF spokeswoman.

NCREIF executives expect the portion of development investments by funds in the ODCE index during the current recovery cycle to surpass the prior peak in 2009 by both gross market value and share of total value. Some 3.2% — $6.3 billion— was in development in the second quarter, compared to 2.7%— $2.4 billion— in the second quarter of 2009, a NCREIF analysis shows.

In all, 5.1% — $10 billion — of ODCE fund capital was in pre-development, development and initial leasing in the second quarter, compared with 5.8%, or $5.16 billion, in the second quarter of 2009. The second quarter 2015 figure represents a big increase from 3.7% in non-core in the second quarter of 2011.

Investors are less sanguine about the rising allocations.

“Anecdotally, I've heard that there is more development and lower occupancy in core,” said David W. Julier, director and portfolio manager, DuPont Capital Management Corp., Wilmington, Del.

Because of rising prices in places like San Francisco and Manhattan, real estate managers are starting to invest higher up the risk curve, said Mr. Julier, who runs a $880 million real estate portfolio.

“To buy straight-up core, stabilized assets is a challenge to achieve the returns they (fund managers) marketed,” Mr. Julier said. “It should be something investors should be aware of. Investors should have an opportunity to understand what is going on in their existing portfolio. The fund may be adding risk where one may not want the risk to be placed.”

In the multifamily sector, for example, it was easy to buy stabilized properties at relatively strong yields after the financial crisis. As the real estate market began to improve, managers bought more value-added properties, those that need some sort of rehabilitation, Mr. Julier explained.

Now managers are investing in multifamily construction, not only in luxury apartments in the white-hot coastal cities such as San Francisco, New York and Los Angeles, but in so-called secondary markets, Mr. Julier said. Secondary market cities include Las Vegas, Miami and Seattle.

“It's a balancing act,” Mr. Julier said. Managers take on the risk and expense of building new projects, finding tenants and doing it all before the next market downturn, he said.

A prime reason managers are adding non-core investments to their core portfolios is to boost returns, said Christopher Macke, managing director, research and strategy at Glendale, Calif.-based real estate money manager American Realty Advisors. “But the purpose of a core fund is to be a stabilizer,” Mr. Macke said.

Core is expected to produce somewhat lower returns in exchange for greater stability. In recent years, core portfolios have managed to outperform or meet the overall index. For example, in the second quarter, the NCREIF ODCE index's return was 3.82%, topping the NCREIF Property index's 3.14%. In the second quarter of 2011, the ODCE return was 4.62% besting the 3.94% of the Property index.

This is not the time to take on more risk in pursuit of returns, Mr. Macke said. It's a time to minimize risk, he added.

Besides, core has been providing double-digit returns on an annualized basis since 2011.

“Why get overly aggressive. They're doing more than necessary,” Mr. Macke said.

Indeed, real estate is the only asset class in which style drift is applauded, but it usually comes at the wrong time, Mr. Macke said. American Realty Advisors manages about $5.7 billion in core real estate.

American Realty Advisors is taking a different approach in its core funds. For example, the firm is focusing on properties with long-term leases rather than aiming for real estate with leases soon to expire in hopes of raising rents, Mr. Macke said.

That is not to say American Realty Advisors doesn't take advantage of its so-called non-core carve-outs, but the percentage in non-core investments is less than 3%, Mr. Macke acknowledged.

Rather than investing in non-core to increase returns, American Realty Advisors does so only if it will serve “to reduce risk,” Mr. Macke said.

American Realty Advisors would invest in development if it can construct a building at a substantially lower cost than it would take to buy an existing building, Mr. Macke said.

“In markets where apartment acquisition costs are 130% to 140% of replacement costs, it can make sense to build vs. buying,” Mr. Macke said.

But if the manager invests in a multiyear mixed-use development, “that is an entirely different use of your carve-out,” Mr. Macke said.

“I cannot make the claim that an investment reduces risk if the development exposes me for an extended period of time to today's uncertain market environment and volatility in the financial markets,” Mr. Macke said.