Sometimes it seems, for an institutional investor, that adding value to a real estate portfolio is as simple as dropping capital into a noncore bucket. Unfortunately, unlike money, investment strategies cannot always be taken at face value.
Investors globally are expecting 65 basis points greater return output from their real estate portfolios in 2016 than they expected in 2015, according to the 2016 Institutional Real Estate Trends survey conducted by Kingsley Associates and Institutional Real Estate, Inc.
This boost is expected at a time when the prices of core buildings are at record highs and after returns from the NCREIF Open-End Diversified Core Equity Fund Index declined in every quarter of 2015. To achieve the returns that they are expecting, institutional investors likely will need to take a more active approach to their real estate investments, putting more emphasis on value-add investment strategies.
This reality has put many institutional investors in a bind. With a palpable concern in the air as to whether the investment cycle is nearing its peak, many investors are wary of adding risk to their real estate portfolios. But determining if now is a good time to drop capital into a value-add bucket is not as easy as it may seem, and may require a closer look at the label itself.
Kicking the bucket
CRE Investing 101 — there are three buckets: core, value-add and opportunistic, which provide, in that order, increased returns at the expense of increased risk. But if you examine these labels more closely, things start to get a little messy.
While there is general consensus in the market as to what constitutes a core building, the latter two definitions have “become blurred, almost interchangeable, as they appear to represent different things to different investors,” explains Nic Fox, partner and head of Middle Europe with Europa Capital.
No clear definition exists as to how much renovation or repositioning is too much to be considered value-add, or at what point the risk of renovating an asset becomes greater than that of a more straightforward, opportunistic development project. Nor is there consensus among different markets as to what level of gearing is too much to be considered core, or too much to be considered value-add.
In general, it is true that the income stream of a traditional value-add project should mitigate more risk than would be found in a development project. But the risks of a development project can be mitigated in their own right, depending on whether, for example, the land is fully entitled, the developer is willing to take on cost overruns or there is any preleasing. Correspondingly, the return for a development project with substantial risk control should be lower than the return for one without, maybe even lower than a “traditional” value-add project.
Muddying the waters even more, an asset that appears to be core — for example, an existing apartment building in Manhattan that is rent controlled — may carry substantial political and economic risk to convert rents to market, possibly more risk than projects found in other buckets. Look no further than 2006’s disastrous Stuyvesant Town–Peter Cooper Village venture in New York City to see it play out.
“Institutional investors are not necessarily well served by having a multitude of different buckets,” asserts Cameron Spry, head of investments with Tristan Capital Partners. Having fewer buckets, such as simply core and noncore, he adds, would allow managers the flexibility to focus on ensuring that they are generating more return than the risk they are taking. Spry believes that this would allow the industry to generate better full-cycle performance and be less prone to chasing returns when risks are elevated.
Sources for this story went as far as to describe the risk from oversimplified bucket labels as “dangerous”, saying that “one of the biggest mistakes” investors make is putting a return requirement on a category.
“The risks undertaken in different value-added investment strategies can vary significantly,” emphasises Dr Cuong Nguyen, head of research with M&G Real Estate Asia. “By considering all of them a single concept, investors could misjudge the opportunity and be poorly compensated for the risk they are taking. A value-add portfolio is going to comprise assets at different levels of risk at the point of acquisition and over time as they mature toward stabilisation and sale.”
Investors must acknowledge that “value-add” as a strategy is not inherently tied to a place on the risk spectrum. It can be a useful definition of a type of investment strategy, but not necessarily for a level of risk and its commensurate return.
Ultimately, prudent investors may have to diagnose the risk of a specific investment — or trust their managers to do so — not simply slot a traditional value-add property in between core and opportunistic on the risk spectrum, and then determine if the return is worth that risk.
Furthermore, an investor needs to look at a range of factors to determine if it is the right time in the cycle to execute a value-add strategy, and may need to kick the bucket labels all together when deciding the timing of execution for any real estate investment.
If the market comes to bear
Despite the potential for the market to peak in the near term, sources for this story generally agreed that value-add investing has a place in a portfolio at all times in the cycle — if done right.
The key is understanding that some types of value-add strategies are better suited for battling bulls than bears, and vice versa, and then implementing the right type of strategy for the current market.
“We believe it is important to construct our value-added/opportunistic portfolio with a larger component of income-oriented assets in the current environment relative to earlier in the cycle,” explains Andy Stewart, managing partner with Argosy Real Estate, adding that it is becoming increasingly important to focus on downside preservation, despite strong supply/demand fundamentals in the United States.
Nguyen also believes, with growth softening throughout Asian regional economies, that strategies focused on enhancing the income quality of a value-add portfolio are preferable at this time. Nguyen notes that this could be achieved by improving tenant covenants to extend leases and reduce leasing risks, instead of boosting capital growth in the short term. Furthermore, he adds, in the current environment, value-add investors should look to leverage as an additional driver of alpha, as he expects a low interest-rate environment to continue for a prolonged period, particularly in Europe and Asia.
When deciding whether to make value-add investments in the current global market, it is equally important to understand that not all value-add strategies follow the standard acquire-renovate-resell strategy implemented on a four- to six-year horizon, as is typically associated with value-add investing.
“We tend to look at noncore strategies as foundational assets that we are comfortable holding for a very long term, and view an early sale as an opportunistic option to garner higher returns,” says Todd Henderson, head of real estate, Americas, with Deutsche Asset Management. Henderson is not alone in seeing the potential for value-add strategies as long-term, open-end plays. Nguyen agrees that approaching value-add in this manner can provide a better entry price to foundational assets, while still allowing the investor the freedom to make strategic dispositions if the right opportunity presents itself.
Globally, the wide range of market conditions means that viable value-add strategies likely are present in every region.
“There remains plenty of opportunity for value-add investing across Europe,” asserts Robert Gilchrist, CEO with Rockspring Property Investment Managers. “With the fixation by many on buying noncore for yield compression rather than value adding, it leaves plenty of opportunities for those with the skills, teams and inclination to value-add to do just that.” Gilchrist notes, with the development cycle subdued in many markets, that strategies focused on repositioning and re-gearing leases are still workable. Furthermore, it is important to remember that Europe’s property markets do not always move in sync, and this diversity “inherently creates opportunity for the experienced value-add investor,” according to Fox.
Similarly, the Asia Pacific region offers a wide range of markets with varying conditions, allowing for an abundance of viable value-add plays. This spans from traditional value-add investments in major markets to riskier ventures in new sectors, such as self-storage and student housing, or emerging markets with less standardisation and transparency.
Though the United States typically is viewed as the most stable venue in the current environment, 2016 offers a couple of curveballs that promise to shake up its real estate market. First are the recent changes to the US Foreign Investment in Real Property Tax Act (FIRPTA) (see box story on page 26), which should greatly ease investment in the United States for international pension plans. Many of these investors will find a dearth of options in gateway core markets and likely will have to look to secondary markets and noncore opportunities to get US properties.
Second, more than $200 billion (€176 billion) in CMBS is scheduled to mature by the end of 2017, according to Kroll Bond Rating Agency, which, when combined with a turnover in the equity capitalisation of LPs, will lead to what Bryan Thornton, partner at PCCP, calls “the great rotation of real estate capital.”
“A record amount of real estate will be required to change hands,” adds Thornton. “This will create opportunity for value-add investors, irrespective of what happens in the global economy.”
The gist is that institutional investors worldwide should be able to find noncore opportunities, regardless of their market and its position in the cycle. But they will need to ensure that they are executing the right noncore strategies for their situations, whether it is a strategy focused on income or growth, a traditional value-add repositioning, or a long-term renovate and hold.
At face value
Some have wondered if the creation of a global value-add or noncore index could lead to industry standardisation of the bucket labels, though such an undertaking would be no easy feat.
“The diversity of noncore real estate makes it very difficult to further categorise it and to create apples-to-apples benchmarks,” explains Deutsche’s Henderson.
Without industry-wide standardisation, investors will be required to decide exactly what they want from a noncore investment, and then determine which specific noncore strategy suits that goal.
“What really matters is that investors and investment managers fully understand investment risks, rather than relying on the labels — even if consensus definitions existed,” explains Kye Joon Lee, director – Asia, with Clarion Partners.
It seems that we cannot quite take noncore investing at face value, and that we may have to learn to view value-add investments as more than simply a drop in a bucket.
At the end of 2015, the United States reformed its Foreign Investment in Real Property Tax Act (FIRPTA) in an effort to encourage investment in US property by international pension plans. Through the PATH Act, certain of these pension plans are now exempt from paying taxes on gains from the sale of US real estate, similar to their US counterparts. Furthermore, foreign entities now can increase their holdings in US REITs from 5 percent up to 10 percent without being taxed on the sale of their real property interests.
After a record-setting 2015 for foreign investment in US property, these changes should bring even more international capital into a market in which the “low-hanging fruits are gone,” according to Kye Joon Lee, director − Asia, with Clarion Partners. As many as 80 percent of respondents to the 24th annual survey of the Association of Foreign Investors in Real Estate (AFIRE) said that it is already difficult to find US real estate opportunities. Still, that did not prevent 64 percent of respondents from indicating that they expect to have modest to major increases in their investments in US real estate in 2016. This reality will push investors, both US-based and foreign, to look outside of gateway markets and at noncore strategies.
Historically, international pension plans have focused their US investments on long-term core strategies to avoid high tax burdens, but the changes to FIRPTA should aid them in their noncore venture because they will be able to execute acquire-renovate-resell strategies without being taxed.
“We think it’s a good thing for the foreign pension plans, and we think it also could be a buffer for rebalancing that may occur as we get deeper into the cycle,” says Todd Henderson, head of real estate, Americas, with Deutsche Asset Management. “The bottom line is, we think it could translate into another $20 billion [€18 billion], plus or minus, of capital coming onshore in 2016.”