For the first time, PREA's survey of US investors gauges end user interest in property derivatives and investor perceptions about real estate fund investment criteria and governance. Jim Clayton reports
Investors are allocating more to real estate, diversifying more internationally and continuing the shift up the risk curve, according to the latest survey of the US Pension Real Estate Association (PREA).
PREA annually surveys its investor members to gather detailed information on current and target real estate allocations, investment strategy, investment structures, and other information not available from public sources, to provide a comprehensive analysis of real estate holdings by plan sponsors and other tax exempt investors.
The survey was conducted in Q4 2007 and Q1 2008. Data are based on the detailed responses from 65 PREA investor members that held more than $3.2trn (€2.1trn) in assets and $270bn of equity in real estate-related investments. Most of the holdings, nearly $245bn, were allocated to private real estate equity, comprising 7.6% of investor asset holdings (Figure 1).
Public (state and municipal government) and corporate defined benefit plans dominate the survey sample, accounting for more than 90% of the total asset holdings of investors responding to the survey, with public plans accounting for the large majority of these, having 83% of assets compared to about 11% for corporate plans. Foundations, endowments and other (union and church pension plans) make up the remaining 6%.
Real estate equity allocations reported are distributed about a mean allocation of 7.3% (Figure 1). The median allocation is slightly lower at 7.1%. Based on investor numbers, allocations are widely distributed among the ranges shown in Figure 2, though when broken down by plan size the greatest dollar amounts allocated to real estate fall into the "greater than 8% but less than 10%" of total plan asset range.
The relatively flat, spread-out distribution of allocations reported in 2007 is similar to that reported in 2006 but differs markedly from the distribution of allocations reported for 2005, which were much more tightly concentrated in the 4-6% and 6-8% ranges. The change over the past two years reflects continued overall increased allocations to real estate, resulting in the movement of a number of plan allocations into the higher ranges in each year.
Members were also asked to report their equity real estate allocation from a year earlier, as well as their current target allocation. Having observations from the same (that is "matched") sample of investors in the two years allows for an accurate measurement of changes in plans to sponsor real estate allocations. Based on the full sample of responses, the average of reported allocations to equity real estate increased from 6.8% to 7.3% (Figure 1). The average of the changes in allocations reported by individual investors is 0.6%, with 52 investors reporting increased allocations and 13 decreased allocations to private real estate. The rate of increase is down slightly from the 2006 survey in which average allocations were up by a full 1%.
The average of the reported target allocations is 9%, up from 8%. Overall, investors increased both target and actual allocations to real estate over the previous year. The mean difference between target and 2007 allocations reported by investors is about 1% for the full sample. Almost one half of the investors responding to the survey had a target real estate allocation in the 8-10% range, and nearly 20% reported target real estate allocations above 10% (Figure 3).
In 2005, more than three-quarters of respondents indicated that their current allocation to real estate equity was below their target level. In 2006 this figure dropped to 63%, as a number of plans reached their policy targets. Figure 3(b) shows that, in 2007, about 60% of investors had not reached targets, broken down either by number of plans or assets. Even though actual allocations increased over the previous year, so did targets.
About 20% of respondents had an allocation greater than their target or policy allocation, though not one of these investors plans to reduce their real estate allocation in 2008. Today, post-credit crisis, there is starting to be some pressure on investors to possibly reduce commitments and in some cases allocations to real estate due to the so-called "denominator effect" as asset values have fallen in many asset classes relative to real estate.
There is significant variation among plans partly hidden by focusing only on averages. While a number of plans are comfortably at allocations close to target, a few large plans have recently announced fairly sizable increases in target allocations to real estate, and there are a number of plans that have only recently added real estate and are still well below target.
Members were asked whether they plan to increase or decrease their percentage allocation to private real estate equity or not make any changes in 2008. The majority plan to maintain their current allocation (66%). Close to one-third (29%) expect to increase their portfolio allocation to real estate equity, while the remaining four (5%) of investors plan to see a decrease in their real estate equity in 2008.
Respondents were asked to allocate their private real estate equity investments into core, value-added and opportunistic strategies based on their interpretation of the relevant definition for each. Not all investors categorise their holdings in this way. Of the 65 respondents, 55 provided details on the investment strategy breakdown. Figure 4 shows the responses from the current survey as well as from the 2004, 2005 and 2006 surveys. Core properties continue to make up the largest share of plan sponsor investments, accounting for almost 56% of equity holdings, although this share is down quite significantly over the past three years. Investment in riskier value-added and opportunistic vehicles each account for 22%, continuing a gradual upward march as investors have shifted out of core.
The changing mix reflects a number of factors, including the quest for return in a low interest rate environment, the belief that value added investment offers a better risk-return tradeoff and also the continued move into global funds, especially those focused on emerging markets. The 2005 survey results revealed that half of US investors responding to the survey had foreign property holdings and collectively, these PREA members held $7.4bn in real estate equity outside the US.
There has been a large increase in foreign real estate activity and exposure. Seventy percent of the US investor respondents report foreign real estate equity holdings totalling approximately $21bn. Adding in the holdings outside their home country and the US of the five non-US investors yields total foreign investment by respondents of approximately $30bn. As in previous years, the bulk of current holdings are in Western Europe followed by Asia.
Investors were asked whether they planned to change the share of real estate equity allocated to core property investments, relative to value-added and opportunistic strategies. Three of the 59 investors that responded to this question plan to increase the allocation to core and 39 (66%) reported no change. On the other hand, 17 (29%) plan to decrease the proportion of the private real estate portfolio invested in core property investments and increase the proportion allocated to value-added and opportunistic investments.
Figure 5 shows the structures of choice for private real estate investment. Most private real estate investment is made through direct investment and commingled funds, with these two structures together accounting for more than 80% of private investment. Direct investment remains the vehicle of choice for larger plans, while commingled funds are more popular for smaller investors.
Overall, the results show a slight continuation of the trend away from direct investment and into funds, especially for smaller capitalised investors. Closed-end funds make up 77% of the commingled fund total, up from 60% in the 2006 survey. Joint ventures account for 11% of private real estate investment dollars, and are also more likely to be a part of the strategy for larger investors.
Members were also asked about public real estate investment holdings. Similar to private investments, equity dominates debt, with equity REITs accounting for more than 95% of public real estate investment and CMBS the remainder. PREA investors held about $24bn in public REITs, comprising less than 10% of total (public and private) real estate investment and are held by slightly less than one half of the plans surveyed.
Domestic REITs continue to play a relatively minor role in tax exempt investor portfolios, though the REIT vehicle is being used more frequently to gain global exposure as REIT markets continue to develop around the world. Twenty eight of the respondents report US public REIT investment holdings totalling $19bn and 18 of these report holding nearly $5bn in global REITs funds or foreign REITs.
In addition to the standard data-based questions, the survey contained a number of new qualitative questions, two or which aim to assess end user interest in property index derivatives and investor perceptions about real estate fund investment criteria and governance.
Investors were asked about their interest level associated with incorporating NCREIF index return swaps into their real estate investment strategy. The market for commercial real estate (CRE) property derivatives has gained significant traction in the UK over the past two years. The US market, however, has been slower to develop.
The survey responses in figure 6 confirm that many investors are indeed watching with interest to see if this new way to invest in and hedge private real estate risk will materialise and revolutionise the institutional real estate world, as it has in stock and bond markets around the world, though none are yet ready to be involved. What is somewhat surprising is the percentage of end-user respondents expressing a complete lack of interest in property derivatives.
The survey also asked qualitative questions about the factors considered when investing in property funds and investor perceptions about the strength of corporate governance in property fund contracts, along the lines of previous work undertaken by INREV in this area. Figure 7 indicates that investment manager track record is the major factor in drawing investors to a fund, with the specific target sector a close second. Fees are a distant third. Both fees and corporate governance related items had started to become more widely discussed and debated as the real estate bull market continued in 2006 and through the early part of 2007. The responses in figure 8 suggest that the majority of investors believe that fund governance has enough teeth. A potential concern, however, is the one-third of investor responses indicating that it is not strong enough in many cases.
Respondents were also asked to explain if and how the 2007 credit crisis had an impact on their 2008 real estate investment strategy. Almost all indicated that it did not or that they were exploring opportunities to capitalise on any further distress, particularly on the debt side. Hopefully putting money with managers that have well established track records and strong fund corporate governance.
The Pension Real Estate Association (PREA) is a nonprofit trade group representing more than 500 member firms, including corporate and public retirement plans, endowments, foundations, Taft-Hartley plans, real estate asset managers, advisors, consultants, investment bankers, real estate investment trusts, and others.
Jim Clayton is director of research at the Pension Real Estate Association