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.