ERES 2013Changes in the real estate asset mix of institutional investors; what will be the optimum for the future?

Prof. dr. P. van Gool FRICS

Amsterdam School of Real Estate / University of Amsterdam / Dutch Railways Pension Fund /

Pension Fund of Public Transport

Friday July 5, 2013

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Topics

I. The role institutional investors in the Netherlands

II. The real estate asset mix of institutional investors in the Netherlands

III. Changes in the real estate asset mix

IV. What would be the optimum mix for the future?

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I The role of institutional investors

in the Netherlands

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Pension income compared to last working income

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Level of net pension income Net replacement ratio (pension income divided by last earned salary)

Poverty of elderly people

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Poverty amongst the aged percentage of those aged 65+ with an income of less than 50% of the median income

II The real estate asset mix of institutional investors in the

Netherlands

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9.5% of total assets in real estate with a mix of 30% direct and 70% funds (of which 52% non listed)

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In € bil l ion

in % in %

Total assets of institutonal investors 1.607,6 100%Of which total real estate investments 153,4 9,5% 100,0%

- Direct real estate (bricks) 46,2 30,1%

> Domestic 30,3 19,8%

* Office 5,6 3,7%

* Retail 10,8 7,0%

* Residential 11,9 7,8%

* Other 2,0 1,3%

> Non domestic 15,9 10,4%

- Indirect real estate (funds) 107,3 69,9%

> Non listed 80,4 52,4%

> Listed 26,9 17,5%

Real Estate Asset mix of institutional investors end 2011

Netherlands

Together with Finland the highest allocation towards real estate (end 2010)!

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Pension funds only!

And the highest non domestic allocation!

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Yes, a small country!

Dutch REIT sector is small!

€ 6bn

Netherlands

5 Reits

III Changes in the real estate asset

mix

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Changes in the real estate asset mix in the Netherlands

• From bricks and mortar (direct real estate) towards funds (indirect real estate)

• Less in offices and more in residential and retail• More in non listed (private) real estate funds, but

with challenges • More allocation of largest and smaller pension

funds towards listed (public) indirect real estate• Open ended funds have to sell their assets• More joint ventures and club deals

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From bricks and mortar (direct real estate) towards funds (indirect real estate)

Disappointing returns private funds

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Challenges private indirect real estate in 2009 and 2010 (I)

– New finance was unavailable– Renegotiating debts: (re) financing was difficult and

sometimes required reducing leverage by forces selling of properties

– No funding for developments and projects in pipe line– Leverage worked (and still works) negative– LTV (loan to value) breaches, forced selling and new

equity required– Defaulting investors

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Challenges private indirect real estate in 2009 and 2010 (II)

– Fall of (rental) income (especially trading funds which couldn’t sell any more)

– ICR (interest coverage ratio) breaches– Forced selling by open ended funds– Fund managers (providers) were not motivated

(no performance fees);– Sometimes fund managers bankrupt due to other

activities (mostly development activities)– Investors were in default (did not want to invest)– Fraud

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Goldman property fund posts 98% loss

16 April 2010An international real estate fund backed by Goldman Sachs has reportedly lost almost all its equity following the poor performance of investments in Germany, the US and Japan.

The fund, Whitehall Street International, carried out highly-leveraged transactions during the real estate boom.

The Financial Times said that the fund is down to $30 mln in equity from an original total of $1.8 bn (EUR 1.3 bn). This corresponded to a loss of about 98 cents to the dollar.

Leverage had ‘horribly damaging’ impact on fund performance in downturn: ULI

15 January 2013• The use of leverage had a ‘horribly damaging’ impact on property fund performance in

the recent market downturn, new research from the Urban Land Institute (ULI) shows. • The negative impact of leverage was greatest for opportunity funds which showed the

highest level of underperformance in the 2001/2011 period compared to core and value-added funds. According to the study, gearing led to 2.2% lower returns per year for every 10% of debt in a fund, equivalent to 13.2% per annum for a 60% leveraged investment.

• The negative impact of leverage was also evident among value-added funds, which typically have more than 40% but less than 60% gearing and aim to generate some of their returns through active asset management. These funds significantly underperformed the market between 2008 and 2011. The research demonstrated that every 10% of leverage within a fund reduced annual returns by 2%.

• Core funds, which typically have little or no gearing and invest in prime assets, performed the best of the three types of investment vehicles and closely tracked the underlying IPD market index until 2009.

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Development total real estate investments mix Dutch investors (in %): more allocation of largest and smaller pension funds towards listed (public) indirect real estate

Pension funds Insurance companies Total

Indirect public

Indirect private

Source: Mosselman, 2013

Direct

Substantial difference in real estate asset allocation largest 25 Dutch pension funds end 2011

(source M. Bakker, 2012)

Largest pension funds have much listed real estate

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Outflows prompt UBS to freeze German open-ended fund

11 October 2010Swiss bank UBS said on Monday that it is halting redemptions from its UBS (D) 3 Sector Real Estate Europe property fund on the back of growing redemption demands from its investors. The vehicle, which had re-opened in October 2009 after over a one-year redemption freeze, will be suspended for a period of 12 months, UBS said.

The fund is managed by UBS' Munich-based KAG fund management unit. According to UBS, the large outflows in the fund were mostly a result of the proposed changes in legislation for German open-ended real estate funds as well as recent developments in the German investment market, such as the dissolution of KanAm US-grundinvest fund.

What do you think?

IV What would be the optimum mix

for the future?

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How to make the perfect real estate mix?

• Asset-only approaches:– Based on the past:

• Sharpe ratio maximizationThe Sharpe ratio is calculated by subtracting the risk free rate from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns. So the higher the Sharpe ratio is, the better.

• Risk minimization– Partly based on the future:

• Risk and return models with forecasted real estate returns and risk scores of different markets, sometimes with historic correlations

• ALM (asset liability management studies); forecasted return with historic relations

• Look in a crystal ball:

What would be the optimal mix with the following possible portfolio?

• Direct real estate – IPD index figures, standing investments, IPD-ROZ for the Netherlands, smoothed and

unsmoothed, no leverage

• Indirect listed (public) real estate – GPR general index World, total return in € (including leverage)

• Indirect non listed (private) real estate – US NFI-ODCE (NCREIF Fund Index – Open End Diversified Core Equity ) with 40% leverage

(proxy for INREV data, only available after 2001)

• Risk free rate (for Sharpe ratio calculation)– 10y state € swap rate

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Outcome of Sharpe ratio optimization(past figures)

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Optimum of Sharpe ratio optimization with Monte Carlo simulation (1978 - 2011)Direct real estate Private real estate Public real estate totalIPD-ROZ smoothed NFI-ODCE GPR General (1984- )

Optimum mix : 86,0% 7,5% 6,5% 100,0%

Sharpe ratio 1,3%Return 8,6%Risk (st. dev.) 5,1%

Direct real estate Private real estate Public real estate totalUnsmoothed IPD-ROZ

Optimum mix: 84,7% 8,2% 7,1% 100,0%

Sharpe ratio 1,1%Return 8,7%Risk (st. dev.) 6,3%

No direct real estate Private real estate Public real estate total

Optimum mix: 0,0% 81,9% 18,1% 100,0%

Sharpe ratio 1,0%Return 9,1%Risk (st. dev.) 9,6%Source: Bakker, 2012

Optimum: most of the portfolio in direct real estate or most of it in private real estate!

Optimum with a ALM model

• Not one optimum but several possibilities!• Optimum % real estate of total portfolio: 15 –

30% With more different alternative asset classes (commodities, infrastructure, private equity etc.) the optimum real estate % is lower!

• Optimum real estate mix between:– Direct real estate: 0 – 50%– Private (non listed) real estate: 50 – 75%– Public (listed) real estate: 25 – 50%

Why is there a range of optimal mixes? Perhaps smoothed assumptions (input in the model) and many more other assets which don’t correlate with each other?

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Always a trade-off between risk

and return!30

(Epra sponsored) research (Harvey & Cheigh and Eichholtz) shows superior returns public real estate vs. direct and private indirect, but don’t mention high volatility and correlation with (normal) equity!

Risk and return model CBRE Global Investors

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Global office markets

Real Estate Investment Risk Score (based on structural and cyclical risk factors

Forecasttotal return (2013-2016)

Concluding remarks

• In the battle between direct and private real estate, direct real estate wins (no leverage, less governance issues and more liquidity), but you need a substantial portfolio.

• In the battle between private and public indirect real estate, public real estate gives higher returns, better quality assets, more spread in the portfolio and much more liquidity, but more volatility and correlation with normal equity.

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Choice depends on:

• Volume of investments (assets under management)• Access to and quality of real estate management• Willingness to get your “hands dirty” by managing direct real

estate (risk of fraud)• Where do you want to invest; national or international scope?• Accepted correlations with other assets• Risk / return profile wanted (core, core+, value added,

opportunistic)• Accepted (non) liquidity and time horizon

Thank you for your attention

Prof. Dr. Peter van GoolReal Estate Economics @UvA, MD Real Estate @ SPF Beheer