A new study from IPD/MSCI reveals concerns at major institutions about integrating property into their wider risk managament. Peter Hobbs and Bert Teuben explain.
The recent MSCI/IPD survey unearthed major concerns at global pension funds and sovereign wealth funds regarding managing the risks of their real estate exposure. The survey confirms the challenges faced by CIOs and risk departments as they seek to oversee real estate exposure and integrate it with other asset classes.
These concerns are highlighted by the following comments from pension funds:
“We have good understanding of real estate in the return space, but not in the risk space,” said a Nordic pension fund.
“One of the key discussion points we are having across our whole portfolio relates to managing the risk assumptions and exposure of the private asset classes,” said a Canadian pension fund.
“I don’t see much from our real estate teams from a risk perspective, and feel the team don’t know much about portfolio risk except for lever- age. There is a case for a ‘no charts’ discussion with the real estate team,” said a US pension fund.
These quotes and other comments gathered by the study demonstrate that real estate risk is seemingly as acute an issue as it has ever been. Prior to the global financial crisis, real estate tended to fall outside of the scope of formal risk management because of its relatively small scale, the idiosyncrasies of the asset class and its tendency to deliver solid performance. But the global financial crisis has changed that. On the one hand, the crisis led to trillions of dollars being wiped off the value of the real estate asset class and concerns over its suitability for investors.
On the other hand, real estate, alongside other alternatives, has become a more significant element of portfolios. In a world that has moved from 60/40 equities/bonds to 40/40/20 equities/bonds/alternatives, the 20% represents a major concern for CIOs and risk officers.
The combination of these factors is leading to greater scrutiny regarding alternatives. This is particularly the case in those regions where there are large alternative allocations, such as North America, UK, the Netherlands and Australia where alternatives account for close to 25% of all assets. It is also the case for the largest alternative: real estate.
Real estate in the wider portfolio
The survey, conducted at the end of 2013, provides a comprehensive review of the role of real estate in portfolios, including the allocations to different styles, the geographic exposure and the approach to execution. The most innovative aspect of the research was examining the approach asset owners take towards real estate risk management.
The survey confirms the importance of real estate to major asset owners. Overall, for the 138 asset owners within the survey, the average holding was 6.7%, representing close to $700bn (€513bn) out of their total $10.3trn assets.
Excluding the nine asset owners with no exposure to real estate, the average allocation is 7.9%. The results are similar to other studies exploring real estate exposure globally, such as those by IP Real Estate. Although representing a large amount of real estate, there are marked variations by region, with the lowest allocations of 3-4% in Asia and Nordics, compared with the 12-13% in Canada and Germany/Switzerland.
The review of the style and geographic focus reveals significant variations across the range of asset owners (figure 3). Real estate tends to play very different roles ranging from low-return inflation-hedging through to high-absolute-return seeking. In most cases it is the range of real estate characteristics (income, inflation hedging, diversification and return) that combine to make it an attractive asset. The survey also reveals that, while home bias remains an important feature for most asset owners, there is a general trend to increase non-domestic exposure, with some having an explicitly global remit for their portfolios.
However, the same combination of characteristics that make real estate attractive to asset owners also creates significant challenges. On the one hand, the combination of a series of complex behaviours make it hard for risk managers to understand and model the risks of exposure to real estate. On the other, it creates the potential for misalignment to exist between the (often poorly defined) role of real estate and the implementation of the real estate programme.
It was within this context that the survey covered two important dimensions of real estate risk management. Firstly, the extent to which real estate risks are integrated with the multi-asset-class investment process, as part of the overall allocation. Secondly, the ways in which the risks of the real estate exposure are monitored and managed within the real estate department, through the strategy and implementation stages of the investment process (figure 4).
The survey supports the challenges faced by CIOs and risk departments as they seek to manage and integrate real estate with other asset classes. These challenges are based on a number of related factors, including the complexity of the asset class, data limitations and a relatively weak understanding of the different roles that real estate can play in the overall portfolio. The combination of these factors has tended to create a gulf between central risk functions (CIO, risk, and allocation departments), and the real estate departments.
Steps being taken by asset owners to improve global real estate integration into the multi-asset-class risk process, include:
• A focused effort to clarify the role of real estate in portfolios, including the risk-return objectives, often leading to different approaches for the various real estate behaviours (such as core, opportunistic and REITs);
• Use of appropriate data for the different real estate behaviours in asset allocation exercises;
• Use of robust models that capture the risks of real estate exposure relative to other asset classes;
• Integration of actual real estate exposure with multi-asset-class analysis.
If the first part of the survey related to the way real estate is integrated within multi-asset-class portfolios, the second part examined risk management within the real estate department.
Although the fundamental reason for the global financial crisis related to excessive lever- age and overheated markets, the difficulties experienced by individual asset owners were based on weak risk management. These weaknesses were often caused by poor alignment between strategy and implementation that led to style drift in the run-up to the crisis.
The survey identified two related dimensions on which steps towards stronger risk management are taking place within the real estate department. Firstly, the benchmarking of real estate, which helps monitor exposure and can ensure alignment with investment objectives. Secondly, the monitoring and reporting of asset and portfolio-specific risks.
The increased desire of CIOs to have greater oversight of real estate departments has led to more use of newly available benchmarks in recent years. The results show that over 70% of the 110 asset allocators (for which benchmark information is available) have some form of policy benchmark (figure 5). Their use is more widespread in established ‘western’ investment markets, with the Asian, German and Swiss asset owners having a relatively low benchmark adoption.
Although relative benchmarks are widely used, the survey reveals inconsistencies in their implementation, often resulting from the use of relatively narrow benchmarks compared with the active decisions being taken within the real estate department (figure 6).
There appears to be two areas in which benchmark misalignment exists. Firstly, the style of real estate covered by the benchmark, with many using a core benchmark for a strategy that includes opportunistic and REIT investments. The second misalignment issue, geographic coverage, is more pervasive, with over 80% of asset owners having disconnects between their geographic exposure and their policy benchmark (figure 6). The most striking disconnection is in the US, where asset owners might, for instance, be using a domestic benchmark (IPD or NCREIF) when they have over 25% of their assets in overseas markets or in REITs.
Beyond the use of benchmarks as risk management tools, the survey reveals considerable effort to focus on more asset and portfolio-specific risks of real estate. Monitoring these risks is seen as a way of avoiding the style drift that plagued many asset owners through the global financial crisis. This risk monitoring can be related to the use of benchmarks, but requires additional data and monitoring.
As stated by one European pension fund: “We do review all the individual projects that we acquire, but are not so good at reviewing the portfolio across our funds and properties. I feel there should be a ‘benchmark tree’ all the way down to help in reporting to the board and in providing discipline for the real estate teams.”
The survey participants revealed that many asset owners receive summary reports on portfolio and asset-risk metrics from their managers or consultants. Although these metrics provide a useful way of summarising the risks of the real estate exposure, there are two distinct shortcomings. Firstly, in terms of the range of metrics covered with a desire for data across a broader set of risk factors, such as lease length and tenancy. Secondly, the timeliness of reporting and valuation accuracy.
The MSCI/IPD survey provides a series of insights into the risk management of real estate within multi-asset-class portfolios, including guidelines for best practice.
One of the central conclusions is the potential for misalignment to occur between the strategic role for real estate and the actual exposure of the real estate portfolio. This potentialfor strategic misalignment is often created by more tactical mismatches, such as the use of inappropriate benchmarks or limited strategic monitoring of portfolio and asset specific risks. Both these mismatches can lead to style drift in the actual real estate exposure.
Although the survey reveals significant cases of potential misalignment, it also identifies asset owners who represent ‘best practice’ in real estate risk management. This spectrum is captured in figure 7 for the two dimensions of real estate in the multi-asset-class risk management process, and the more specific process of real estate risk management.
The chart reveals four main types of asset owner. On the bottom left there is a group of less sophisticated investors with minimal formal real estate risk management and poor integration between the real estate team and the broader portfolio (‘laggards’). A number of these investors are relatively new to real estate investing, and are starting to improve processes on both dimensions. But there is another group within this category that have relatively large real estate teams that have tended to operate in a semi-autonomous way from the rest of the portfolio.
The group of investors in the top left quadrant tend to have a highly sophisticated strategic perspective on the role of real estate, with clear risk-return objectives, as well as tools and processes to integrate with multi-asset-class risk monitoring (‘theorists’). Despite this sophistica ion , there tends to be a disconnection between the strategic objectives and the implementation of the strategy. This is often due to relatively weak asset and portfolio-specific risk metrics within the real estate departments.
The largest group of asset owners is bunched in the middle of the diagram, with efforts being made to monitor the risks of the real estate portfolio and to integrate this with other asset classes (‘industry norm’).
Although most asset owners are seeking to improve their risk-management processes, they almost all fall short of the fourth category, the ‘global leaders’, identified in the top right-hand quadrant. Such asset owners tend to be very sophisticated in most aspects of real estate risk management. They tend to have a sophisticated understanding of the role of real estate and strong risk tools to integrate this analysis with the rest of the portfolio.
These insights are particularly relevant considering the structural and cyclical forces that will be brought to bear on real estate investment in the future. Structurally, real estate has become an important element of the multi-asset-class portfolio, and has started to move beyond its home bias to becoming a truly global asset class. This increased significance has occurred despite the severity of the losses of the global financial crisis. The combination of these factors has led to greater scrutiny from risk managers and CIOs, and a desire to better integrate real estate with broader multi-asset- class risk management.
Cyclically, the recovery in real estate markets coupled with concerns over pricing of other asset classes is leading to a surge of capital towards real estate, and to concerns over the pricing of the asset class. This weight of capital will test the resolve and the skills of asset owners as they try to maintain alignment and manage risks through the investment process.
It is hoped that this survey into best practice is of use to asset owners and managers as they strengthen their investment processes.
Peter Hobbs is managing director and Bert Teuben is vice-president at IPD