June 18, 2014
Interviewed by: Zoe Hughes
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Time To Look to Value-Add

The performance of value-added and opportunistic funds comes under the spotlight with our panel of experts including Cambridge Associates and PREA.

The performance of value-added and opportunistic funds comes under the spotlight with our panel of experts including Cambridge Associates and PREA.

Time to Look to Value-Add

Real Estate Performance

Zoe Hughes, PrivcapRE:

I’m joined today by Marc Cardillo of Cambridge Associates, Greg MacKinnon of PREA, and Kevin Higgins of Crossroads Advisors and former head of America’s Swiss Re. Thank you all so much for joining me.

We’re here to talk about one of the most important issues in private real estate for institutional investors: performance. It’s certainly why a lot of institutional investors allocate to the asset class. Yet, when it comes to transparency on performance, particularly for value-add and opportunistic, the industry is certainly looking for more clarity and more information.

Thanks to our panel of experts here today, we’re going to provide and start that discussion. Marc, I want to open with you. Looking at some recent quarterly performance figures, we want to look at what’s driving performance, but describe what Cambridge does in terms of looking at performance and the benchmarks you do.

Marc Cardillo, Cambridge Associates:

Our real estate benchmark comprises about 700 funds. These are comingled, closed-end funds, value-added, opportunistic, core plus, comprising about $450 billion of total capitalization or equity capitalization of funds raised between 1986 and 2013.

The mix is probably about 60% opportunistic, 40% value-added. Looking at it by geography, it’s probably about 60% U.S., 20% Europe, 20% Asia and other. That includes looking through the global funds and attempting to determine where those properties are located.

Hughes: What are you seeing in terms of the latest performance figures? How does that look for the performance for the last few years?

Cardillo: As you’d expect, performance has improved and it’s been strong for the last three or four years. Our numbers through the third quarter of 2013 showed private real estate in our benchmark up a bit over 11% percent on a trailing three-year basis. That’s comparable to a public real estate benchmark that’s comparable but slightly lower than our private equity, our venture capital benchmark.

Hughes: You mention that it’s comparable to some of the public real estate and I want to bring Greg in on this point. It’d be useful to try to compare the value-add and opportunistic benchmarks and what you’re seeing in terms of performance with what’s happening in the core space. Describe to me what PREA tracks and what you’re seeing on that side of the equation.

Greg MacKinnon, PREA:

We co-publish the PREA/IPD U.S. property-fund index, of which there are two versions. The main version covers all open-end real estate funds whether core, value-add, diversified, or sector specialist. We also put out a sub-index that is just core diversified. In terms of comparing performance between what Marc’s seeing in the value-add and opportunistic space, what we’re seeing in the core-diversified space 2013 return net to investors was a bit under 13%. On a three-year basis, it’s about 12.5%. In the core space, those are very strong numbers.

Hughes: Core definitely seems to be performing much better, even when you take it over one, three, or five years. Is that what you’re both seeing out there in the market?

MacKinnon: Certainly over the last five years, core has outperformed. The value-add and opportunistic space is a riskier space, which should generate higher-average returns in the long run, but the whole concept of risk is that there’s a risk that it will not generate higher returns. Given the financial crisis and the bad returns in 2009, that’s what’s happened in this case.

Kevin Higgins, Crossroads Advisors:

To pick up on something Greg said, you’ve got the core funds generally being a strong performer over the past five years. You have to add the leverage into that equation. Most core assets are unlevered or very lowly levered. Value-add and opportunistic—you’re looking at 70% or 80% in this past cycle. That’s adversely impacted the performance of value-add and opportunistic.

Hughes: What role does leverage play?

MacKinnon: One great thing with a PREA/IPD index is that provides an extra level of transparency beyond just the headline fund-return number because IPD—who is in charge of gathering and crunching these numbers—is looking at the entire fund from headline return to investors, all the way down to the properties owned, through the leverage and everything else. They track all those things.

For instance, on a gross-of-fees basis, the 2003 return in the index was just under 14% and you can break out where that comes from. About 3% was due to leverage on the core funds. The underlying, unlevered properties returned about 11.5% in 2013. You can see not just what the headline is but how much is from leverage and how much from the properties and other bits and pieces in there.

Hughes: What role does leverage play when you’re looking at the Cambridge figures and how’s that been driving performance?

Cardillo: Our numbers are fund-level numbers, so we’re looking at everything on a levered basis. It’s difficult, as much as we try to decompose those numbers for a levered and unlevered return. To the extent that an opportunistic fund is performing better than a value-added fund, clearly that should be expected because there’s typically more leverage in that opportunistic number.

When we’re looking at the numbers, you need to take a qualitative view and recognize that the value-added category is generally going to be more lightly levered than the opportunistic funds.

Hughes: If we do a comparison looking at core, value-add and opportunistic, where are some of the best relative values today?

Cardillo: Despite the fact that looking backward, core has outperformed on an absolute basis and also on a risk-adjusted basis, the value-added pace is one we favor going forward. There are good opportunities for managers to buy, maybe not distressed assets but assets that have been neglected for the last four or five years that have been able to receive a lot of CAPEX. So, there are opportunities to add capital to those properties and fill vacancies. That basis is more interesting to us than core and more interesting than opportunistic, where again, the longer-term track record of those managers generating a decent risk-adjusted return just isn’t there in the numbers.

Hughes: How do we weigh risk in today’s performance figures?

MacKinnon: That’s the big question that all the investors are talking about. I’m not sure I have a great answer, because at the end of the day, no one’s really sure yet exactly what risk is and how you measure it. A lot of the measures used in the public security space, like volatility and whatnot, are used in real estate. They’re not useless, but they don’t tell the whole picture. So, it’s hard to get a good grip on what risk is. There have been attempts to compare core, value-add, and opportunistic on a risk-adjusted basis using volatility as a risk measure.

A PREA/IPD study recently did that amongst other things. Value-add didn’t come out looking that good on a historical basis, but the thing to keep in mind is that there’s a lot of transparency in some of the value-add and opportunistic numbers. We weren’t using Cambridge numbers in that, but… I’m sure Marc would back me up in this. It’s harder to get consistent, accurate data on those kinds of funds. Doing these kind of historical studies is problematic, to the say the least.

Higgins: Picking up a transition from historically, value-add has not had the returns over the past five years to being a target for performance. I tend to look at risk like peeling back an onion. You look at operational risk, at leasing risk, and at market risk. It’s just a puzzle that you just have to keep pulling apart, layer by layer.

Hughes: When we look across the risk spectrum, where is the performance coming from? Is it more capital gains, are you looking leverage, or is it NOI growth?

Cardillo: Again, it’s a combination of the three. Leverage ratios are lower than they have been historically but still, leverage is accretive to returns. Managers, both in the value-add and the opportunistic side, have been able to acquire properties with a healthy, unlevered yield. Again, they are able to lever that to an attractive number. In the last couple of years, there has been significant capital appreciation, primarily unrealized, but we are seeing managers start to sell properties from post-financial crisis funds.

Hughes: If you talk anecdotally, you would argue that many of the performance figures have been driven by capital gains in today’s market. What are you expectations as you look out in 2014 and 2015?

Cardillo: They’ll be good years for performance. The real estate market’s in a sweet spot where demand is strong across most of the property types and markets. Supply increasingly is becoming an issue, perhaps more so in certain markets or property types, but the next few years should be a good time to be owning property. From a vintage-year perspective is maybe a separate question, because the 2014 vintage year, for example, how will that look?

Hughes: What are your expectations in terms of performance when you look out over the next two years?

MacKinnon: In the core space, being at PREA, I have no expectations. We do a consensus forecast survey every quarter and the latest numbers show people expecting an unlevered basis, at least in the core space—returns slowing down somewhat going forward. The most recent numbers were 8.7 for this year, 7.7 for next year. Certainly not a crash in values, but a mitigation in the returns going forward from the strong returns we’ve had in the past.

Hughes: With a moderation in the core-performance returns, does this mean we should be seeing greater returns from the value-add and opportunistic space?

Cardillo: We think so. Again, looking historically, the numbers would suggest we may be naïve to think that, but looking at relative opportunities today, we think the value-added is likely to outperform core.

Higgins: Especially to the extent that you’ve got increasing occupancy, you’ve got rental rates that can be moved a bit. There are some markets and sub-markets where they’re turning into a landlord’s market again.

Hughes: But have we hit a peak at the moment? Do you think we’re going to see a peak in terms of performance figures as well?

Cardillo: When you look at our data by vintage years you can see the cyclicality of real estate and you can see that 2009, 2010 will be very strong vintage years. The returns will start to decelerate, so I expect that it’s inevitable to see some deceleration. But, relative to a lot of other asset classes and equities, real estate looks like it still should be a decent place to be investing.

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