Market neutral alternative real estate funds: they are new, but what makes them special, especially in these somewhat stressed investment times? Graham Barnes reports
What is meant by ‘alternative' investment? Conventional investment is based on long-only, generally ungeared, positions in developed market listed equities, bonds and property. Most real estate funds are conventional funds dependent on income and/or market-driven asset price appreciation for their returns.
Alternative investment covers the strategies that are not permitted by conventional investment such as the use of leverage and the ability to adopt short positions, often through the use of derivatives and structured debt (CMBS). Therefore, it can be argued that opportunity-type real estate funds would fit within the alternative universe. Within the alternative universe there is a wide range of strategy types and risk profiles ranging from those targeting special situations and emerging markets to statistical arbitrage to short-biased funds to market-neutral and relative value.
Market neutral funds are neither net long nor net short in terms of their exposure to their underlying asset class. Consequently, they are non-directional and do not depend on the market rising or falling to generate returns. For example, the real estate equity market, as measured by EPRA, and the UK's physical real estate market, measured by the Monthly UK IPD, declined by 33% and 9.5% respectively between May 2007 and March 2008. A market neutral fund on the other hand is capable of delivering a net positive return over the same period.
So how do such vehicles make money? There are a number of different approaches to profitable market neutrality but most focus on market exploiting inefficiency, or arbitrage, or relative value.
Relative value funds seek to identify where assets are being valued differently and, being slightly simplistic, buy the cheap ones and sell the expensive ones. The asset classes involved would typically include equities, funds and derivatives. The use of derivatives in relative value strategies is important as they offer the ability to take short positions. Index derivatives, especially those relating to other than equity indices, are particularly useful in an asset class specific fund as they allow a short position to be taken without the volatility which accompanies short positions in equities.
The emergence in recent years of an increasingly liquid market in real estate index derivatives, usually in the form of IPD swaps, has been an important development in facilitating the introduction of relative value methodologies to the real estate industry.
As far as the fund is concerned, whether real estate values are rising or falling is not the key concern. Rather, the focus is on the rate, and direction, of movements in the prices of real estate related instruments. The differing dynamics of the universe of financial instruments provide a consistent stream of relative value trades. However, volatile, and especially dislocating, markets present particularly interesting opportunities.
Alternative funds can also be usefully divided into single-strategy and multi-strategy categories. Single-strategy funds benefit from having a clear focus but are exposed to the effectiveness, or otherwise of that strategy in the market conditions of the time. The principle benefit of multi-strategy funds is the diversification of their sources of performance and risk. Alternative funds as a whole tend to be either predominantly statistically based, using trading strategies based on sophisticated mathematical models, or predominantly fundamentally based, using strategies based on bottom-up research and analysis.
In some cases the strategies of a multi-strategy fund are underpinned by a combination of sophisticated statistical and probability models and detailed financial and real estate analysis. This combined quantitative and fundamental approach is central to the fund's management style.
The different strategies focus, respectively, on relative value differences within or between instrument types and have varying time periods over which profits are realised.
Real estate often earns its place within multi-asset class portfolios because of its decorrelation benefits. Individual real estate assets tend to demonstrate a low correlation to the real estate market as measured by, for example, the IPD index.
However, even comparatively small portfolios of real estate demonstrate relatively strong correlations with market benchmarks. Consequently, it is difficult for real estate specific investors to diversify away from the market benchmarks without taking, for example, significant sector concentration risks.
Equally, for multi-asset class investors, there is a level beyond which real estate, in any given market, cannot add to their diversification. This can be addressed by adding new geographies or emergent real estate asset types to the real estate portfolio. These approaches provide issues of their own including the level of specific risk exposure, market understanding, marginal costs, liquidity and the ease of execution.
Alternative investment funds offer a different approach. Most alternative strategy types claim to have low correlations to other investment assets classes and are employed to reduce the level of correlation within a portfolio. Perhaps too much has been made of these claims by the alternative investment industry and there is evidence that certain strategy types do exhibit strong correlations to their underlying markets in times of distress.
On the other hand an alternative fund may exhibit very low correlations to real estate and other investment asset classes.
The other issue that is regularly raised with regard to alternative investment strategies is risk and the recent well-documented failure of a number of funds emphasises this concern. Clearly, the strategies alternative funds employ and the markets in which they invest do tend to carry risks that are not commonly run within conventional long-only approaches.
However, failures of businesses in general and failures within the alternative space tend to exhibit common features, namely a high degree of leverage combined with position liquidity problems arising from a rapid deterioration in market conditions. The net effect is that the fund/business runs out of money regardless of whether or not it is fundamentally still profitable. In short, borrowing too much money is risky almost regardless of the business you are in. It has been reported that one recently failed fund employed leverage of 33:1.
Clearly leverage on this scale does not allow much room for even a very temporary reduction in market liquidity, let alone error.
By way of comparison, one might wish to consider the exposure to the directional risk of market value declines of a geared real estate fund. For a fund geared at 50%, a 15% decline in capital values (as recently experienced in the UK) would result in a 30% decline in net asset value. This is a serious decline, but probably not enough to result in the immediate demise of the fund.
However, the same market conditions would result in a 50% decline in the net asset value of a fund geared at 70%. While a 50% LTV may be regarded as close to the upper limit for the gearing of institutional real estate funds in the UK, it still means that a 30% decline is not just readily imaginable … it has just happened! So, at the risk of repetition, the sources of potentially fatal risk tend to be common regardless of strategy style.
So, in these uncertain times, alternative funds offer an interesting addition to the universe of conventional real estate investment vehicles. From a market-timing point of view current market volatility and the dislocations arising from the credit crisis are very positive for relative value strategies while at a portfolio level they enables a manager to increase his exposure to real estate and increase the diversification of his portfolio as a whole without taking market direction risk.
Reech CBRE Alternative Real Estate is a joint venture between Reech AiM Group and CB Richard Ellis in the UK and Graham Barnes is a member of the investment management team, Reech CBRE Alternative Real Estate