Core, core plus, value added, opportunistic - are these terms of art or science in the world of indirect property investment? Noel Manns reports
I was at a drinks party recently when a well-known and experienced head of real estate for a major UK group recounted a conversation with a junior colleague. Reporting on a potential purchase for their fund, the junior colleague had said: "The property will be a core holding and has lots of angles" to which the well-known real estate investor replied: "If it is core with a sub 4% cap rate, then there shouldn't be any angles!"
In the complicated world of property funds, what do these terms "core", "core plus", mean and do they assist investors and their advisers in navigating risk/reward decisions on strategies for investment?
Thanks to US-based organisations such as NCREIF and, particularly, INREV in Europe, there have been attempts to provide a classification of funds into certain risk/reward categories, these being core; valued added (sometimes referred to as core plus) and opportunistic funds. This approach defines funds largely upon projected levels of return but finds it difficult to complete the picture by measuring the risk taken as part of the methods to achieve those returns.
In 2005/2006 INREV (The European Association for Investors in Non-Listed Real Estate Vehicles) surveyed its membership on return expectations.
The research, confirmed by a debate at its conference in Rome in the second quarter of 2006, suggested that expected returns were 5%-10% for core funds; 10%- 15% for value added funds and above 15% for opportunity funds.
But what about other variables, such as leverage, which can have a dramatic impact on returns both positive and negative? For those of you who have experience only of the bull run investment market since 1996, leverage is a good thing. But those of you with a little grey hair will be able to remember a time when leverage sucked all the income returns out of a portfolio while asset values were dropping!
INREV addressed this issue in its survey and it seemed that, then, the core returns might be achieved with leverage up to 50% (based upon NAV); added value returns with leverage up to 65% and opportunistic was only for the brave who were prepared to accept the extra volatility of returns that leverage brings. More on this later.
We have seen a plethora of fund launches in the past few years employing these definitions, and investors and others have been able to navigate the risk/reward parameters of the market in confidence… or have they? I am not so sure.
First, let's look at the titles. We have seen a number of new funds labelled core plus. What does this term mean? Is it a US expression for value added or does it sit somewhere between core and value added? Does a core manager just sit back, take beta returns and do no active management, whereas value added managers roll their sleeves up and create value?
Are opportunistic funds meant to have a strategy or do they hide behind a cloak of leveraged opportunity to hide a lack of strategy? One of the clear trends (until interest rates increased) was for opportunity-style funds to buy core assets, maximise the leverage applied to them and watch the returns roll in. Now, is that value added management?
Now, having offended everyone, or at least questioned their style of management, I offer an example of the debate from our own investment experience. Europa Capital manages, through a network of country partners, a number of opportunity funds, focused on the European and Eastern European markets At Europa Capital we aim to add value through active asset management but we also develop new buildings. We can leverage up to 75% over a fund but usually our percentage leverage is in the mid-60s.
Some of our investors categorise us as an opportunity fund, others as a value-added fund. A key determinant is how much of the return is driven by income and how much by development. We actually see ourselves as a "value-adding fund" through very active asset management and repositioning strategies. Our leverage level is more akin to an added value fund.
Returning to the issue of leverage and today's market conditions, more than two years on from that INREV study, interest rates have increased but returns have been good, across the spectrum. But it is noticeable that both value added and opportunistic managers have been straying into the value creation space. Are value-added managers starting to take risks that they are not qualified to take - such as speculative development - or have the possible returns from opportunity funds reduced in line with projected market returns and/or the potential to lever assets?
It will be interesting to see the results of the INREV 2007 Investor Intentions Survey to see what returns investors now expect from each style category. Thankfully, INREV has proposed a review of this very issue.
INREV is holding a workshop for members this month and will issue a paper in 2008 following that review. My guess is that investor views have changed; that required risk-adjusted returns, which reduced during the intervening period, are now on the increase again as uncertainty and volatility return to the markets and because those ever important swap rates have increased.
So, returning to the drinks party comment on core holdings. Is a core asset or core fund self evident or, rather, should we dig a little deeper into levels of leverage; location /geography; sector and manager skill set to establish just what those returns are to be generated from (eg, from income; market timing/mispricing or development) and what types of risk are really being taken? Time spent on reconnaissance is seldom wasted.
Noel Manns is principal and co-founder of Europa Capital
