Core, core plus, value added, opportunistic - are these terms of art or science in the world of indirect property investment funds? 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 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", etc 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 Q2 2006, suggested 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 involved only in the bull run investment market since 1996, leverage is a good thing. For those of you with a little grey hair, you can remember a time when leverage sucked all the income returns out of a portfolio while asset values were dropping.
INREV addressed this issue in their survey and it seemed, then, the core returns might be achieved with leverage up to 50% leverage (based upon NAV); added value returns with leverage up to 65% and opportunistic was only for the brave who were prepared to accept all that extra volatility of returns which leverage brings. More on this later.
We have seen a plethora of fund launches in the last few years employing these definitions and investors and others have been able to navigate the risk/reward parameters of the market place 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 an American 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 get stuck into value creation? 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, at least 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, I offer an example of the debate from our own experience. Europa Capital manages, through a network of Country Partners, a number of opportunity funds, focused upon the European and Eastern European markets. 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 have leverage in the mid-60s percent. 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 both value added and opportunistic managers have been straying into the value creation space. Are value added managers starting to take risks which 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 in November 2007 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 - are they 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.
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