Are core, value-add and opportunistic labels useful to investors or potentially misleading? Richard Lowe considers the latest thinking
The standard labels used to describe real estate investments – core, value-added and opportunistic – have come under renewed criticism.
The classifications, which are used to denote low, mid and high-risk strategies, are long-established, but their helpfulness to investors has been routinely questioned.
There is confusion over whether the labels should apply to just investment strategies or also to individual assets. An opportunistic fund, for instance, targeting 20% returns could feasibly buy a core asset, such as a well-let, CBD office from a distressed seller.
The classifications are well established in the US, and in Europe INREV has put them at the heart of its industry best-practice guidelines, before effectively exporting them to Asia via ANREV.
INREV’s own definitions have come under criticism, particularly in relation to leverage, and it has revised them over the years. In short, it has moved from classifications based purely on leverage and target returns to what it terms “a bundle of risks”.
Table 1 shows the main determinants of style under INREV’s most recent definitions, which centre on the different sources of target returns and leverage levels.
As INREV states, the classification “does not imply that there are no other risks which impact the performance of non-listed real estate funds”. Country allocation, for example, is a risk variable (Greece would imply a higher risk than Germany) but it is deemed less relevant for fund styles. “It is therefore preferential to have a country label next to the style classification,” INREV reported when it updated the definitions. It cited examples: “French Core fund or Iberian Value Added fund.”
Landmark Partners, which invests in real estate funds via the secondary market, has asked “how useful” the fund class distinctions are in a new paper (see Differences in class, opposite), particularly as it finds little difference in the investment performance of value-added and opportunistic funds.
“This finding calls into question the usefulness of class labels and suggests that investors need to investigate specific managers and the details of their intended strategies in order to assess expected risk and returns,” the report concludes.
Fidelity Worldwide Investment has also questioned the usefulness of the classifications – in fact, it suggests they might be quite “dangerous” for risk management. In a new paper (see Looking though the label), it also criticises the use of these investment ‘style’ labels alongside sector and market-specific labels, often combined in the form of ‘core German retail’, for instance.
“There is over-reliance on geographic, sector and style labels,” the report says. “Such labels, while useful in many ways, can mislead because they fail to capture the true risk of real estate assets.”
Instead, Fidelity argues in favour of looking through these three labels at the underlying cash flows. This is predicated on a conclusion from the research: income returns are more important than capital returns. This approach has important implications for portfolio management and diversification.
“Geography and sector labels are crude measures for assessing risk, returns and diversification,” the report says. “The traditional approach tends to assume that geographic diversification is the key measure for achieving portfolio diversification.”
Fidelity’s research suggests that true diversification can be achieved by concentrating on cash flows and by constructing portfolios that have different lease lengths and structures.
“The biggest single determinant in diversification and performance is lease structure,” says Matthew Richardson, director of research at Fidelity. “It was the length of the lease, the structure of the lease and the ability of those leases to generate cash flow. What we also discovered on a statistical basis is that we could diversify away a lot more risk and volatility on the fund performance by mixing and matching different lease lengths and lease structures then we could by buying in different geographic locations.
“It really throws the cat amongst the pigeons, because you are then challenging the whole basis of all the recent asset allocation theory in property, because you are saying fundamentally it’s flawed.”