Private equity real estate needs a hefty dose of Darwinism, according to Ian Laming

The investment strategies of many private equity real estate managers took a mauling during the crisis, yet a surprising number of thm are out there raising capital again. Compared with the ruthless culling that has occurred in hedge funds, or equity and fixed income investment vehicles, there's not a lot of Darwinism operating in the non-listed real estate world. Why?

I think it's because it's so hard with non-listed real estate to benchmark and compare managers. The law of the jungle and ‘natural selection' can't work efficiently if investors lack the tools to measure which species of manager or which strategy is best, and which is destined for extinction. We risk being seen as the dinosaurs of the investment industry if we don't change our tune. We must evolve and create more sophisticated benchmarking tools to compete effectively for capital against other investment asset classes.

I'm a real estate guy now, but if you look at my old stomping ground - the securities industry - you can see what could be possible.

Academics and practitioners in the securities industry have responded to client needs and created an entire industry to help investors track and compare managers. Ratings agencies such as Morningstar and Lipper assess fund managers with ‘fact sheets' full of all manner of data, graphics and background. Investors can compare top-10 holdings and geographic splits. They can monitor performance weekly, daily, or even real-time on Bloomberg. They can compare returns on an absolute basis, or by benchmarks. The risk metrics are extensive: volatility and semi-variance analysis, Sharpe ratios, information ratios and all manner of Greek letters. The securities industry has created standardised metrics with frequent data series to help investors understand what they are buying; track risk-adjusted returns, and benchmark fund managers.

But investors in non-listed real estate don't have the luxury of definitions and statistics. They're under pressure to explain their asset class, yet the lexicon is undeveloped, the metrics are poor, the terms are misunderstood, and little is standardised. As a result, it's difficult for investors to assess a non-listed fund manager's track record or its investment approach. Comparison between managers is an art, and a vague one at that.

The non-listed real estate industry has another disadvantage: funds cannot mark to market much more than once a quarter. Data series capture infrequent snapshots of the market cycle, so statistical analysis is constrained.

The industry's credibility is suffering, and the need to address these problems is becoming urgent. Slowly but surely the non-listed real estate industry is responding.
INREV is at the forefront: its new investment style guidelines provide a much better framework for assessing a manager's investment styles and risk-adjusted performance, because they look at a better range of factors - leverage, development exposure, percentage of non-income producing assets and percentage of return from income - rather than just target returns and leverage.

INREV has also replaced manager views on fund styles with statistical analysis and back-testing of risk factors. Three types of fund clusters surface, based on data collected from more than 200 funds. Yes, these clusters are labelled in traditional terms - core, value-added and opportunistic - but their genesis is a function of statistical proof based on credible factors, not anecdotal and gut-feeling. Critically, the framework is locked down so that fund managers cannot change the criteria from year to year to suit their marketing needs.

This is huge step in the right direction for the industry. Over time, more risk factors can be added and investors will get more granular benchmarks. We'd urge investors to study the INREV changes and demand that their managers provide the data needed to make them work.

A second provider of analysis, NAREIT, has launched a ‘real estate portfolio optimiser'. This tool helps investors compare the returns, volatility and Sharpe ratios (risk-adjusted return) of different real estate portfolios. It compares the portfolio performance of publicly traded REITs and private equity funds based on 18 years of data. The constraint here is that the index is US-centric, and runs counter to some academic research about gearing and benchmark construction issues when comparing equity real estate returns with non-listed fund returns. That said, it creates new tools, and expands the debate.

A third strategy is being pursued by Preqin. This service will further change the way investors track, compare and select managers. Preqin specialises in alternative asset classes, many of which suffer from the same problem as real estate - constrained data sets and a fluid vocabulary for styles, leverage and risk. Preqin combats these problems by gathering data, but also by pursuing a qualitative route of manager and investor interviews to corroborate the data. These interviews offer rich insights for investors to consider.

It's a great start: a triple dose of standardised metrics and definitions from INREV, quantitative data and analytical tools from NAREIT, and the data and views from Preqin. Just what investors need to sort the wheat from the chaff.

Some big questions remain though. Will managers play ball? Do they really want to be evaluated? Will the bad ones want to show they have no clothes? Maybe investors should tell them they can't be chosen if they don't provide the data to these new services? Do investors have the stomach for that?

And even if increasingly reliable benchmarks are created, the good managers will only contribute if there's value in it for them and it helps them raise money. INREV and the investors can create new rules, but they also have to make sure that the good managers don't just survive; they need to thrive.

Let's hope investors and managers get behind these changes so that manager experience, reputation and track record stand out as paramount, and that only those who add value - and can prove it - will survive.