This article is an excerpt from ULI’s new book, The Investor’s Guide to Commercial Real Estate.
Portfolio management is the art and science of making decisions about investment mix and policy; matching investments to objectives; allocating assets for individuals and institutions; and balancing risk against performance. Portfolio management is all about strengths, weaknesses, opportunities, and threats in the choice of debt versus equity, markets, growth versus safety, and many other trade-offs encountered in the attempt to maximize return at a given appetite for risk. Portfolio management in real estate is still relatively recent compared with equities and bonds, but certainly most of the precepts apply.
There are some limitations to the application of portfolio management techniques to real estate:
- Real estate is lumpy, chunky, and not easily divisible.
- Like snowflakes, each piece of real estate is unique and often highly idiosyncratic.
- There are high frictional costs with searching for, buying, and selling real estate that are quite material to the transaction.
These factors inhibit the free, optimal portfolio construction and rebalancing that portfolio management entails. Finally, real estate has been considered a highly inefficient asset class with relatively poor information available compared with other major asset classes. This paucity of information, particularly for private real estate, makes portfolio management difficult at times. However, it also makes real estate an attractive asset class, as there are informational advantages to those participants who can develop positive informational asymmetries.
Two types of real estate portfolio management exist: passive and active. Passive management simply tracks a market index, commonly referred to as indexing or index investing. Active management involves a single manager, comanagers, or a team of managers who attempt to beat the market return by actively managing a fund’s portfolio through investment decisions based on research and decisions on individual holdings. The goal of an actively managed portfolio is to generate returns in excess of a passive portfolio, hence “beating the market” entails reference to an index or a series of indices that track returns. Let’s first delve into the origins of portfolio theory and how exactly it can be applied to the real estate asset class.
Modern portfolio theory (MPT) is a theory of finance that attempts to maximize expected returns for a given amount of portfolio risk—or equivalently minimize risk for a given level of expected return—by carefully choosing the proportions of various assets. MPT, widely used in practice in the financial industry, is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. This is possible, intuitively speaking, because different types of assets often change in value in opposite ways. A key issue in diversification is the correlation between assets, the benefits increasing with lower correlation. However, this is not always known in advance, since the future return on any asset can never be known with complete certainty. This was a serious issue in the Great Recession of 2008–2009, when assets that had previously had small or even negative correlations suddenly became highly correlated (at some point, it seemed that all correlations were 1.0), causing severe financial stress to market participants who had believed that their apparent diversification would protect them against any plausible market conditions, including strategies that had explicitly claimed low or even negative correlations. For example, to the extent that prices in the stock market move differently from prices in the bond market, a collection of both types of assets can, in theory, face lower overall risk than either individually. But diversification lowers risk even if assets’ returns are not negatively correlated—indeed, even if they are positively correlated.
More technically, MPT models an asset’s return as normally distributed, defines risk as the standard deviation of return, and models a portfolio as a weighted combination of assets, so that the return of a portfolio is the weighted combination of the assets’ returns. By combining different assets whose returns exhibit low correlations, MPT seeks to reduce the total variance under the assumptions of market efficiency.
Portfolio theory is often criticized for relying on an assumption of normally distributed returns. Under this assumption, only mean and variance of returns matter to an investor. This is often a gross simplification of and a deviation from reality, particularly for real estate. First, returns tend to have fatter tails than a normal distribution. This implies that extreme events occur more frequently in actuality than they would be expected to under the normal conditions that serve as the basis for portfolio theory. Consequently, standard deviation is not a good measure of risk, as it does not encompass the complexity of the situation in reality. Second, the normal distribution is symmetric—each side around the mean being a mirror—but the distribution of returns in reality is not. Actual return distributions being asymmetric implies that, first, the concept of standard deviation again does not capture the complexity of the risk environment, which should depend on the lack of symmetry of an asset class’s return distribution; and, second, the standard deviation is too simplistic because it includes both upside and downside risks, which are not of equal concern to investors and not equal in asymmetric distributions.
Benchmarking is the process of comparing the performance of a business segment against the industry or its peers. Without a benchmark, performance has no reference and an investor has no basis against which to measure a manager’s effectiveness. In the context of real estate investment management, benchmarking is commonly used to evaluate a fund against peers that have similar investment mandates and styles for purposes of incentive compensation. Benchmarking is also used to evaluate an investment management firm, the overall real estate sector against other asset classes, and a single property against other properties in the same market.
Everything from financial and investment structure to allocation (life cycle, property type, vintage, and geography) to selection and operational management decisions should be compared with other industry measures to monitor that the portfolio is on track to exceed the overall benchmark. Decomposition of a benchmark can assist in risk management as well as in formulating strategies through research and portfolio attribution. These disciplines lie at the heart of a strategic organization’s ability to outperform and add value for its clients.
Investment managers should perform a comparative analysis of each of their firm’s investments (properties) to understand the operational effectiveness of their management styles. Understanding the details of the way a fund or property performed relative to multiple benchmarks provides additional clarity for the reasons of outperformance or underperformance. Based on these factors, model allocations are developed with the primary focus on the long-term investment objective of the mandate. Importantly, consideration is also given to the short-term horizon, which enables a more tactical element and is particularly helpful in planning the investment phasing of the mandate. As a result, model allocations address stage and sector diversification based on industry analysis and timing within the real estate market cycle.
In the investment implementation phase of the process, consideration will be given to the optimal number of fund investments to achieve diversification without approaching declining marginal benefit. It is also important to consider the number of potential investments available within a given geographic and sector allocation. Although there may be an attractive opportunity for market exposure, the optimal investment vehicle may not be available. Finally, it is important to note that the ultimate risks and returns of a new private real estate fund may not be known at the time of investment. This is particularly true with regard to a blind-pool investment program, in which one seeks to gain exposure to a given market through a defined strategy, but details of the ultimate capital deployment are unknown.
Valuing Real Estate at the Property Level
For many commercial real estate investments, the value of the property is determined by the amount of income it is able to generate. A discounted cash flow (DCF) model estimates the value of a property by discounting back to the valuation date all future expected cash flows arising from that property. In practical terms, it requires the following:
- An explicitly forecasted stream of cash flows over a given investment horizon or holding period,
- An expected value that is assumed to exist at the end of the holding period (often referred to as the “terminal value” or the “exit value”), and
- A discount rate that reflects the market and specific project risks.
The estimated cash flows of a property should reflect both income (for example, rental receipts) and expenditures (for example, property taxes and capital investments). Typically, cash flows are explicitly forecasted for five, ten, or 15 years. The duration of the forecast period should be based on lease expiry dates, lease renewal periods, and break clauses (including the probability of breaks from the lease occurring). Valuation is affected by the timing of cash flows. Therefore, the more accurate the cash flow frequency is (monthly or quarterly rather than just annually), the more accurate the resulting valuation will be.
The following cash outflows should be included in the DCF model:
- Cash used in the initial investment, including loan points and fees if financing is part of the structure;
- Cash expenses associated with operating and owning the investment property, including income and capital gains taxes;
- Capital expenditures for redevelopment or refurbishment of the property during the holding period; and
- Expenses associated with the disposal of the property (selling costs).
The following cash inflows should be included in the DCF model:
- Periodic income or rents collected from the investment property, and
- Expected proceeds from the disposal of the property at the end of the investment holding period.
The exit value represents the price that the investor expects to receive for the property at the end of the holding period. This expected value should take into account the anticipated physical condition of the property, rental growth, leasing terms and remaining tenure on the exit date, and movements in interest rates and property yields.
Typically, exit values are calculated by applying an exit cap rate to the expected market rent at the end of the holding period. All else being equal, the higher the terminal cap rate used, the lower the exit value and vice versa. Historical evidence indicates that terminal cap rates have varied dramatically from 3 to 12 percent. A typical rule of thumb would be 7 to 10 percent, with a higher cap rate used for properties with a riskier profile.
Evaluating the Fund Manager
During the investment implementation phase of the process, individual fund investments are evaluated as a means to achieve the model portfolio allocation. Analysis of investment opportunities in private real estate attempts to address three paths of inquiry:
- Is the investment strategy sound given the objective?
- Is this the best fund manager to implement the strategy?
- Does the structure provide appropriate alignment between the fund manager and the investor?
The client’s return objectives and mandate constraints are considered along with constraints that the multimanager believes are appropriate to avoid excessive risk. Examples of such constraints include the following:
- Limit on percentage ownership of a vehicle
- Limits on portfolio leverage
- Limits on or diversification of investment duration
- Minimum and maximum number of fund allocations
- Sector allocations relative to a benchmark
- Limits on exposure to development
- Limits on exposure to a single fund or a single manager
- Limits on exposure to a single sector
- Limits on exposure to emerging or frontier markets
- Limits on exposure to a single region or country
- Limits on, or diversification of, currency exposures
- Legal and tax structure considerations
- Investment style and ethical considerations.
The combination of all individual investment risks is called portfolio risk. Generally, portfolio risk is categorized into two main risks: systematic and unsystematic.
Systematic risk is the risk associated with the structural macroeconomic changes affecting the entire market. It cannot be diversified away or reduced through asset selection or diversification. All assets (stocks, bonds, or real estate) are exposed to market risk, including: recessions, tax law changes, structural changes in the economy, wars, terrorism, and consumer preferences. The major components for the broad market comprising systematic risk usually include: business cycle risk, market volatility, inflation, interest rate risk, liquidity risk (related to real estate), and marketability.
Unsystematic risk is the unique risk associated with a particular company or industry. Unlike systematic risk, unsystematic risk can be reduced or even eliminated through asset diversification. Unsystematic, or nonmarket, risk in real estate has been difficult for portfolio managers to wrestle with over the past 30 years. Portfolio managers have concluded that much of traditional real estate unsystematic risk could be reduced or even eliminated through geographic and property-type diversification. Unsystematic risk decreases as more investments are added to the portfolio, and interestingly, the level required to achieve this is not as great as one might expect. For example, various stock market studies place the number of stocks as low as 15 to gain adequate diversification and elimination of unsystematic risk.
The risks generally associated with real estate include:
- Liquidity. Real estate is considered to be an illiquid investment because it is difficult to quickly sell an asset for cash at the asset’s market value.
- Unique (nonmarket) or “unsystematic.”
- Market or “systematic.”
- Interest rate. Associated with the movement in interest rates, and when an inverse relationship exists between price and interest rates. However, unlike debt, real estate has an income component that can change with economic conditions and can lessen the impact of an increase in interest rates with a decrease in prices. The stimulative interest rate environment between 2003 and 2007 created significant real estate price appreciation, which drove returns to near all-time highs and precipitated the residential and commercial real estate crash.
- Purchasing power. Also known as inflation risk, this is the risk associated with the decline in real returns of an investment with the increase of inflation. As with interest rate risk, nominal interest rates often increase with the increase in inflation, thus compensating for the loss of purchasing power.
- Pricing. Private real estate does not continuously trade on the open market. As such, an asset’s market value must be developed through an appraisal rather than through efficient market pricing.
- Exchange rate. The risk that exchange rates move against domestic currencies will continue to be an increasing risk characteristic for real estate, as international real estate investment continues to increase.
The risk profile of a real estate asset that is owned free and clear can be changed by adding leverage (debt) on the property and by creating a joint-venture investment structure with another investor.
Economic and Geographic Concentration
Economic and geographic diversification is based on the idea that risks and returns of real estate vary according to their location. Different geographic locations have different economic and demographic drivers that affect short- and long-term property returns. That is, correlations among geographic markets are less than 1—which is typically the case. There are many levels of geographic diversification—international, national, regional, metro, and submarket. Effective geographic/economic diversification results from selecting investments in areas that have fundamentally different economies.
Another form of diversification is by market type: primary, secondary, or tertiary markets; and further, central business district (CBD) and suburban markets. The definitions are not hard and fast. Primary markets generally refer to large metropolitan statistical areas (MSAs), generally with at least several million in population. They typically have large, diverse economies supporting a variety of industries and economic activities. They tend to be a part of larger urbanized zones—such as the East Coast urban corridor, for example. They also tend to have more barriers to supply—these could be physical, economic, or regulatory. Secondary markets are often those with 2 million in population and below. They tend to be a bit more specialized in terms of their economies. They tend to be less supply-constrained. Finally, tertiary markets tend to be small—less than 500,000 in population, usually disconnected from larger urban areas, and tend to have the fewest constraints on supply.
Over the last two decades, an important trend has been occurring in the United States—increasing urban densification. Since the end of World War, the United States had been characterized by a strong suburbanization/urban decentralization trend. While suburbs continue to grow, over the last 20 years the urban core of many large primary and secondary cities began to grow again, fueled by younger people, high-tech employment, and the idea (rightly or wrongly) that dense urban areas were more interesting and offer a greater range of economic and cultural opportunities. Suburban real estate markets tend to be less expensive. Investable assets there are usually less capital-intensive and often low-rise. These markets are also less supply-constrained in most cases. Though there are supply-constrained suburbs such as Greenwich, Connecticut, and Walnut Creek, California, they tend to be the exceptions. Suburbs have encountered issues with aging infrastructure and increasing crime and traffic. Many residents, suffering the effects of longer and longer commutes and rising fuel costs, have traded suburban living for urban living.
CBD assets tend to exhibit higher prices and the assets themselves tend to be higher density and older, reflecting the difficulty and expense of replacing CBD assets. Most CBDs of major urban areas are more supply-constrained. There is usually less volatility in CBD markets as they tend to be economically deeper and more diversified with a more stable and mature tenant base. Due to their central location and importance in their regional economies, CBD properties are generally well positioned for income growth and value appreciation during economic expansions. Most larger institutional and foreign capital investors will invest only in CBD markets.
Property Type Diversification
The basic concept behind property type diversification is that returns and risks vary according to the particular tenant, credit, geography, and industries using various types of property. Diversification by industry, like geographic diversification, is usually attempted on several levels.
Diversifying a real estate portfolio by property type is similar to diversifying a securities portfolio by industry. Different property types cater to different sectors of the economy. For example, office property generally responds to the needs of the financial and services-producing sectors; industrial property to the goods-producing sectors; retail property to the retail sector; and hotels to the travel and tourism sectors, employment growth, and the business cycle. Understanding the return and risk factors attendant to different property types requires understanding the factors affecting each property type’s user groups.
Like geographic diversification, industry diversification must be sensitive to the diversification requirements of the overall portfolio. For example, an overall investment portfolio heavily invested in the stocks of financial institutions and securities firms is already vulnerable to some of the same risks affecting office property investments in the financial center cities of New York, Los Angeles, and Chicago. Similarly, the value of industrial real estate holdings is sometimes adversely affected by changes in environmental legislation, and such holdings should probably be limited in overall investment portfolios heavily invested in environmentally sensitive industries.
Lease Diversification: Term, Quality, and Tenancy
Lease structure diversification can be conceptualized as real estate investments as bond portfolios, noting bondlike attributes in the tenant leases. Consequently, we often analyze leases with regard to tenants’ credit ratings, tenants’ businesses, lease length, and the value of the leaseholds.
It is important to evaluate tenant credit ratings according to the senior corporate debt of the lessees. Tenants’ businesses are typically analyzed in terms of government-generated standard industrial classification (SIC) codes that differentiate between manufacturing and service-oriented companies and allow for further differentiation of specific types of manufacturing (e.g., electronic equipment) and service organizations (e.g., finance, professional services). Leases are compared with regard to their length (including renewal options), which may vary considerably, typically from ten to 20 years.
The lease structure of a property or a portfolio of properties has a significant bearing on the property’s or portfolio’s inherent risk and return profile. A key objective of the portfolio strategy is to create a diversification of tenant mix (in terms of credit quality and business), and lease maturities can be effective strategies for minimizing a property’s or portfolio’s operating risks. For example, an office property portfolio heavily weighted with noncredit tenants, tenants in similar or complementary businesses, or leases expiring in any short period of time may be prone to higher operating risks than more thoughtfully diversified portfolios.
Three major economic aspects of market location are normally considered in selecting an area for investment: 1) its size, density, and maturity; 2) its general and long-term economic growth potential; and 3) the extent to which its economic/industrial base is diversified.
We favor economically diversified areas, since they tend to be more stable and less vulnerable to shifts in the economy. Employment concentration ratios (also known as location quotients or shift/share ratios) are a method for analyzing the breadth and diversity of an economy. These ratios compare the concentrations of employment in each local sector with the economy of the entire nation. When an industry’s ratio is greater than 1 (1.0), the area employs more workers in that industry than the national average. Similarly, if the concentration ratio for an industry is less than 1, the area employs fewer workers in that industry than the national average. An average at or near one is good because it reflects a well-diversified economy. In some instances, an area shows a strong dependence on a particular industry. For example, Dallas, Denver, Houston, New Orleans, Tulsa, and Oklahoma City are very dependent on mining, including the petroleum and other energy-related industries; Washington, D.C., is dependent on government; and New York is dependent on finance, insurance, and real estate.
The economic/industrial base is very important. Economically diversified areas are better. Although a propensity for growth is usually a desirable characteristic in the market, it can be a negative on the supply side of the equation. Although supply must be somewhat flexible for a real estate market to continue to grow and evolve, when possible we seek out markets with natural and/or artificial barriers to new construction. Constrained growth in development keeps rents—and consequently property values—higher than would otherwise be achieved.
Active Portfolio Management
Driving the fund toward a successful exit strategy while bearing in mind the fund objectives and principles and investors’ interests is a key function of active portfolio management. It is important to develop portfolio strategies that are consistent with the allocation ranges of the target portfolios and the current and expected conditions of properties in the portfolio.
Active portfolio management assumes low to moderate market efficiency. In an efficient market, information is processed quickly and disseminated efficiently and asset prices adjust according to this new information. In efficient markets, there is little benefit to asset selection, research, or marketing-timing approaches. In active portfolio management, mispriced market segments and properties are worth seeking out. A passive portfolio approach assumes moderate to high market efficiency, and the costs of finding mispriced market segments and properties are spurious. Under the passive approach, the portfolio manager should focus on constructing and maintaining a low-cost index or proxy portfolio that matches the beta of the market. Real estate is generally considered to be less efficient than the stock and bond markets due to:
- High transaction costs;
- Paucity of publicly available, audited information;
- Lumpy, large assets;
- Idiosyncratic nature of each asset—no two are alike; and
- Complexity of local and state laws around acquisitions, finance, operation, and taxation.
The broad goals of the portfolio strategy are established return, risk, diversification, liquidity, financing, etc. This creates two things: it creates commitment and/or “buy-in” to the implementation strategy proposed and provides a reality check by the individuals in the firm with the best knowledge of property and market conditions.
Monitoring and Rebalancing
Monitoring and rebalancing are essential parts of our portfolio management. Even the most passive investment management styles require some monitoring and rebalancing. Monitoring and rebalancing also introduce the dimension of time into the portfolio management process. The portfolio management steps discussed thus far (objectives and constraints, market conditions and expectations, target portfolio determination, and portfolio strategy determination) are completed by analyzing all available information as of a point in time. Monitoring and rebalancing convert the portfolio management process from a static snapshot into a continuous, dynamic process.
Monitoring captures the dynamics of change that affect real estate values such as tenant credit, lease terms, and local real estate markets. Monitoring considerations also include portfolio-level metrics including total portfolio size, return requirements, risk tolerance, liquidity, debt ratios, time horizon, and the market. If conditions and/or expectations change significantly enough, the investor/portfolio manager will initiate a rebalancing of the portfolio. The market analysis includes consideration of data at the macro level down to the property level. A range of diversifiable and nondiversifiable risks (below) are considered.
As with equities and bonds, the real estate portfolio manager will be top-down, bottom-up, or a combination of both. The top-down approach focuses on the investment decision at the national level, then regional, and then local levels. The bottom-up approach examines the assets first and assumes that markets are not efficient and that mispriced assets exist.
Rebalancing is the process of modifying the assets within the portfolio to make them better fit the changing needs of the investor and market conditions and expectations. Rebalancing can take one of three forms: 1) allocation changes between market segments (e.g., Chicago office to Atlanta retail), 2) category or emphasis changes in a market segment (e.g., regional malls to power centers), and 3) selling a property and replacing it with another of like kind. The determination of if and when to rebalance within the current portfolio is the operative question.
The vehicle or form of the investment has a significant effect on the return and risk characteristics. What vehicles are available for investing in real estate? Real estate can be managed directly or indirectly, and actively or passively.
Direct investments include the direct purchase or financing of existing properties or properties under development or redevelopment. The direct control over the selection of properties can potentially lead to high returns. However, returns are highly dependent on the skill of the investor. Since there is no free lunch, these higher returns usually entail greater risk and have lower liquidity than some other types of real estate. These direct investments are usually large, chunky, and highly concentrated by locale and property type.
Commingled funds can be open or closed-ended, and can be either equity or debt funds. Both open and closed-ended funds give investors the opportunity to purchase units in a pool that owns real estate, mortgage instruments, or a combination of both. These funds allow investors to diversify investments by property type and geographical area without allocating large of amounts of capital and without the property management burdens. However, investors trade off the right of direct control such as the decision to buy or sell properties.
Real estate investment trusts (REITs) offer another form of indirect investment vehicle. They allow investors to purchase shares in an investment trust that pays no federal income taxes if at least 90 percent of taxable income is distributed to shareholders. This avoids the double-taxation issue faced by most corporations. Another significant advantage of REITs is that they provide liquidity and daily market-quoted prices (in the case of publicly traded REITs). One downside is that stock prices of REITs are highly correlated with the stock market and exhibit the volatility characteristics.
Real estate syndications generally allow investors to purchase limited partnership interests in real estate that may be sold privately or publicly. These vehicles are structured to allow taxable income and losses of the partnership to pass through to the partners with no liability affecting the partnership entities. Syndications tend to charge substantial fees and tend to be undiversified and illiquid compared with other types of pooled investment vehicles.
Investments in capital market instruments are another way to invest in real estate indirectly. For debt instruments, these include mortgage-backed bonds, which are mortgages or bonds that are purchased in the secondary market. These instruments are originated by financial institutions, serviced through an intermediary, and then sold as packages in the marketplace. These investments provide a relatively high annual cash flow return and a low risk of default. However, they are exposed to inflation risks and generally do not provide for call protection or prepayment risks.
The common stock of publicly traded real estate companies provides the most indirect form of real estate investment. These firms exist across a spectrum of real estate activities—housing, finance, manufactured housing, and development. This type of investment provides liquidity, diversification, and daily market pricing. However, stock market volatility applies and often the underlying real estate assets are undervalued.
Diversification by Strategy
Value-added investment. In general, overall return and risk levels fall after the development process, particularly when the property is “stabilized.” Stabilization refers to a property that is complete and tenanted. Some investors and advisers focus on a particular phase of the property value cycle and seek investment managers who specialize in those particular areas. Some investment firms might be known as good acquirers—creating value through the buy—others might be known as good underwriters, others excellent financiers, others leasing experts;, while others might be good at timing the market, and selling at the right time.
Opportunistic investment. Opportunistic investment involves higher risk—such as buying distressed assets or engaging in development. The returns can be higher; but because of the nature of the assets and also because the real estate market is often in flux, it is difficult to accurately represent returns.
The Investor’s Guide to Commercial Real Estate (ISBN 9780874203493) is available through ULI’s online bookstore for $124.95 (The Canadian price is $149.95 and ULI members receive a 25-percent discount; for details, e-mail firstname.lastname@example.org or call 800-321-5011).