Real Estate and Portfolio Theory

1. Real Estate and Portfolio Theory • Lecture Map • Review of Portfolio Management Theories • Asset allocation using the efficient frontier • Immunization and liability hedging • Role of Real Estate in an Investment Portfolio • Asset selection within the Real Estate Asset Class • What do institutions want from their real estate investments? • Is there a ‘best way’ to select real estate investments?

2. Real Estate Investing in the Context of Portfolio Theory • Investing in real estate offers an ideal fit with portfolio theory • Efficient Frontier → low correlation → diversification → fixed income and appreciation attributes • Immunization → fixed income attributes → ‘alpha’ enhancement opportunities

3. Portfolio Management Theories • Efficient Frontier Theory • Optimize combination of assets along the “efficient frontier” to maximize returns relative to acceptable level of risk • Diversify portfolio using mean variance theory to reduce correlation of returns • Immunization Strategies • Select base portfolio to cover projected stream of liabilities • Balance of the portfolio invested to enhance returns – i.e., increase “alpha”

4. The Efficient Frontier • In theory, investors should maximize returns at the margin for the amount of risk they are willing to bear • “Risk” in this case is measured by the volatility of returns and the correlation - or lack thereof - of relative returns across asset classes • Assets are worth more in combination than individually if optimally combined based on the covariance of their returns

5. Defining the Frontier • Frontier represents unique combinations of assets that optimize risk adjusted returns • i.e., optimal covariance between holdings in portfolio • At each point along the Frontier, there are no “dominant” portfolios • i.e., no portfolios that offer greater return given the risk level • Any other asset combinations either increase risk for same or lower returns, or decrease return for at least the same level of risk • Adding imperfectly correlated assets to a portfolio extends the efficient frontier to the NW, providing better reward to risk payoffs • The lower the correlation, the greater the benefit of diversification

6. Portfolio Selection Using Mean Variance Analysis • Start with the expected returns and the covariance between the different asset classes. • Find the mean-variance efficient portfolio of the different asset classes. • If the expected returns of the different asset classes change over time, asset allocations change • Investment managers in practice are continually “re-balancing” their portfolios against the target

7. Mathematics of Mean Variance Theory Rj – rf = a + B(Rp – rf) If a is positive, then the portfolio underweights asset i. Example: Suppose that real estate has a beta of .3 wrt the reference portfolio, and an expected return of 4% above the risk free rate, and the reference portfolio has an expected return of 6% above the risk free rate. Then real estate will have an a of 2.2%, implying that the reference portfolio underweights real estate. To find the optimal portfolio, iterate until all the alphas are zero.

8. Real Estate and the Efficient Frontier(from the NAREIT site)

9. CAPM and The Efficient Frontier • CAPM takes the risk adjusted return theory down to the asset level • If markets converge around risk/return expectations – the market clearing price for assets – then only the relative risk of one asset versus others matters at the margin • Diversification should eliminate asset specific risk • “Beta” management • Implies that all investors at any given risk level or return target should have basically the same assets in their portfolios at each point along the curve

10. CAPM and Asset Allocation • Choosing the asset mix of your portfolio • Growth stocks • Value stocks • Fixed Income • Real Estate • Direct • Commingled Funds • REITs • Should the asset mix change over time? • Timing • Style Rotation • Does the CAPM really help with asset selection? • Especially with selecting real estate investments?

11. Special Challenges for Real Estate in the Efficient Frontier Model • The mean variance asset allocation model suggests that pension funds have been historically underweighting real estate and value stocks. • One theory is that these models ignore reinvestment risk. • Suppose that expected rates of return on risky investments decline. • This causes asset prices to increase (which is good) but implies that new investments will realize a lower rate of return (which is bad). • Growth stocks tend to realize the highest returns in these situations, and thus provide the best hedge against a reduction in reinvestment risk. Hence, growth stocks deserve a higher allocation than implied by the mean variance model.

12. Special Challenges for Real Estate with the Efficient Frontier Model (cont.) • In practice, it is very difficult to measure covariances for real estate • A number of studies assume unrealistically low covariances for real estate which result in very high allocations • Versus the mean variance theory which traditionally has underweighted real estate • Historical data is not as robust as it is for stocks, bonds, making measurement even more difficult • Private real estate markets are also fragmented, inefficient, illiquid • Some properties correlate well with bonds – single credit net lease deals, multi-family • Others exhibit high volatility – hotels, suburban office • Performance can vary significantly between properties, markets

13. Another Challenge of the Mean Variance Model • The mean variance model also ignores pension liabilities. • Plan sponsors would like to generate income that matches their liabilities. • Liabilities are likely to increase with income levels. • One might expect real estate returns to roughly increase with increases in income, which would make real estate more attractive than the predictions of the mean variance model.

14. Real Estate, Re-Balancing the Portfolio and the Efficient Frontier • Lack of liquidity in private real estate poses a challenge in re-balancing • Institutions favor direct deals that offer some relative control over exit timing • Benchmarking against target returns and indexes is also problematic for real estate • Most targets are annual • Most indexes are benchmarked quarterly • Real estate is a long term asset!

15. REITS and the Efficient Frontier Model • Where do REITs fit in: are they really a different asset class than real estate? • Need to also ask whether REITs are different than other value stocks. The high allocation to REITs in some studies ignore the substitution between REITs and other value stocks. • At least REITs offer the ability to build a long term data base with the mark - to – market characteristics of stock and bond indices • Should improve the analysis of REIT covariances over time

16. Portfolio Immunization • Investment strategy based on meeting planned and/or projected liabilities versus a target rate of return • Methodology splits the portfolio into two pieces: • Core investments indexed to liability streams • Generates income to match size, timing of liabilities • Ties well with fixed income investments • Balance of the portfolio invested to enhance total return • Alternative assets, equities, etc. • “Alpha” management • Works best with fully and/or overfunded pension plans • Underfunded plans are by definition behind the total return curve in meeting even known liabilities • May need to take more risk to meet obligations

17. Portfolio Immunization (cont.) • Immunization is getting lots of attention in the portfolio management world today: • “Post bubble” phenomenon • Institutional portfolios severely hurt by tech boom/bust • Portfolio discipline was missing in over-allocation to tech, private equity and venture capital • Concern over looming obligations to retiring baby boomers

18. How Big was the Bubble?

19. Other Attractions of Immunization • Stop the proliferation of ‘asset classes’ • Immunization would classify assets by their role in the portfolio as opposed to role in diversification • “what is the job” of each asset? • Inflation hedge; current income; long term growth • Addresses concern that covariance analysis may be less relative as the global economy gets more interdependent • Will whole markets and asset classes become more vulnerable to each other? • How efficient is asset allocation today anyway? • Look at real estate fundamentals vs. pricing • Are we creating another bubble of a different type?

20. Why Real Estate Looks So Good in the Immunization World • Real estate combines return features of both bonds and stocks with low correlations to those asset classes • Current income and total return • Same argument used by the efficient frontier model, but for immunizers, the current income provides a hedge against liabilities; growth component offers “alpha” • Real estate also offers multiple investment strategies within the asset class to enhance alpha • Opportunistic plays • Property type and sector plays • Market selection

21. Does Immunization Work? (or, Does it Really Make Any Difference Which Approach You Use?) • Does this strategy makes sense for portfolios that were severely damaged in the bust? • Significant number of pension funds today are underfunded • Evidenced by stress on Pension Benefit Guarantee Corp. • Is the eventual portfolio outcome going to be that much different under this theory than under efficient frontier theory? • Both call for diversification • Both require a minimum return target • Both look to increase alpha on a relative basis, or against selected benchmarks • Can real estate be effectively used as an immunization tool?

22. Role of Real Estate in An Investment Portfolio • Regardless of theory, widely agreed today that real estate should be a part of every investor’s portfolio • Also generally agreed that investors are on average significantly underweighted in real estate • Institutional universe has approximate 2% of assets in real estate • This small allocation still represents $80 billion in privates, $12 billion in REITS and REOC’s • Only the largest pension funds invest in real estate • 25 largest funds control 74% of all pension fund investments in real estate • Control 82% of all pension investments in REITs • The rest of universe hasn’t shown up for the party!

23. Institutional Real Estate Strategies • Involves Selection of Investment Vehicles and Managers • Primary Investment Vehicles: • Private Equity Real Estate Funds • Core • Value-Add • Opportunistic • REITs • Market proxies • Regional, property type plays • Direct Deals

24. Institutional Real Estate Strategies (cont.) • Implementation of any strategy is critically dependent upon manager selection • Expertise and track record • Deal experience • History of producing targeted returns • Transparency • How good, frequent, honest is the reporting? • Alignment of Interests • Incentive-based reward structure

25. Institutional Real Estate Strategies (cont.) • Institutions invest disproportionately in private, direct deals today • Public REIT markets, universe of private equity funds too small to accommodate available capital • Selection of, relationship with manager is key • Real and/or perceived ability to influence operations and outcome of the investment • Facilitates periodic rebalancing if needed • Less liquidity than a REIT, but more than a fund with a greater degree of control over the asset, exit timing

26. Real Estate Investment Strategies – Moving Beyond the Vehicle • Real Estate provides multiple opportunities to enhance returns at the margin – “alpha” – in all investment vehicles • Stage and/or strategy selection • Property type allocation • Regional allocation • Market Selection • Property Selection • What are the selection issues? • Correlation between strategies • Long term economic and demographic shifts

27. Value-Added Strategies Return and Risk Attributes for Investment Stages and Strategies Entity Investing Development Forward Commitment Development Lease-up,Re-tenantingor Renovation Re-capitalization Core Risk Attributes ForwardCommitmenton Development Core Re-capitalization Lease-up Development Entity Investing • Stable Market • Class A & B Properties • Prime Location • Objective: 8-10% IRR • 80% + • Operating Partner Risk • Reduced Level of Control • 40-90% Leverage • Objective: 18% + IRR • Leasing Risk • JV Structure • Retain Control • Objective: 10-12% IRR • Substantial Initial or Near-term Vacancy • Low Initial Yield • Objective: 11-13% IRR • Minimal Construction Risk • Minimal Zoning/Entitlement Risk • Fund at Completion • Leasing Risk • JV or Wholly-Owned • Objective: 12-14% IRR • Limited Construction Risk • Leasing Risk • Minimal Zoning and Entitlement Risk • Objective: 13-18% IRR Renovation • Major CapitalExpenditures • Increase Revenues • Objective: 11-13% IRR

28. Property Type Allocation • Office and Industrial properties are most cyclical, most closely reflect economic cycles • Office → either the best or the worst performer. A lagging indicator. Time the cycles, underweight suburban “commodity” deals in general • Industrial → generally outperforms office, more stable returns than office. More of a leading indicator. • Retail and Multifamily are considered more stable • Retail → negative correlation with office, good absolute returns. Reflects consumer-driven economy • Multifamily → considered defensive, counter-cyclical. Influenced by demographic trends as well as job growth

29. Regional Allocation • Property type selection within regions is important • Gets back to economic base analysis! • What industries, activities drive the local economy and will be reflected in real estate needs? • East and West • Higher returns, higher risk • More heavily concentrated in office product because of the financial focus of coastal economies • Midwest • Correlated with the East coast, although more heavily industrial in nature • South • Low correlations with West, higher risk adjusted returns on average than either coast • Long term demographic shifts favor the south

30. Market Selection • Drivers of Market Selection: • Employment growth and comparative economic strength • Ease of adding new supply • Historical absorption track record • Property preferences → which do better in given market? • International vs. National Markets: • Direct comparisons are difficult to make • U.S. market is a “traded” market; foreign markets are not • Long term holds might favor stability of yield in W. Europe • Does the recommended diversification model apply here? • Prologis strategy: provide U.S.-style service to customers in foreign markets • Goldman approach: move opportunistically in and out of international markets

31. Property Selection • Pick your size • Smaller assets has historically outperformed larger assets • Wider audience offers greater liquidity • If your holding period is short, evaluated exit opportunity • Pick within asset classes • Suburban vs. CBD office • CBD considered more stable • Regional mall vs. power center vs. neighborhood center • Neighborhood center in favor • Flex R&D vs. distribution • Flex R&D is more cyclical • Garden-style multifamily vs. high rise, urban condominium • Garden-style considered more generic and defensive • Full service, limited service, resort hotels • Luxury full service most defensive, resort most cyclical