Core real estate funds in the US enjoyed a bumper year in 2021. But major disruption of the long-standing sector is far from over, write Christopher Walker and Richard Lowe

When COVID-19 struck, things initially looked bleak for core real estate funds in the US. One reason was the uncertainty; core funds tend to be big owners of office and retail assets, which were immediately affected by lockdowns.

In March 2020, Allison Yager, global leader for real estate at investment consultancy Mercer, told IPE Real Assets: “Right now we are all trying to figure out [the] short- and long-term consequences for the real estate industry. One thing we can assume is that last week’s value assumptions are no longer valid.”

Another reason for the bleak outlook was related to asset allocation. Steep falls in stock markets automatically pushed up US pension funds’ weightings to private markets at a time when they were already relatively close to their target real estate allocations.

Douglas Weill, co-founder and co-managing partner of Hodes Weill, told IPE Real Assets “many institutions are telling us that they’re at or over-allocated to real estate”.

In May 2020, IPE Real Assets reported on the gating of a number of the large open-ended core property funds as well as expectations among US pension funds – their Principal investor base – that more would follow suit.

Since then, net cash flows into core open-ended real estate funds, as measured by the NCREIF Open-end Diversified Core Equity (ODCE) index, have been in negative territory, but in the latter half of last year began to recover. For the last three months of 2021, quarterly investor net cash flows (investor contributions less distributions and redemptions) were back in positive territory at $470m (€435m), after a negative $800m in the previous quarter.

And although net cash flows into ODCE funds were negative for 2021 as a whole, the sector still attracted a substantial volume of contributions at $20.6bn (distributions and redemptions were $24.3bn).

For example, Los Angeles County Employees Retirement Association recently revealed plans to invest at least $2.4bn in ODCE funds in the coming years. The $59bn pension fund is considering investing between $400m and $800m per fund, which could number between six to eight.

California State Teachers’ Retirement System (CalSTRS), one of the largest US public pension funds, remains an ODCE investor, although it has changed how it invests. The pension fund has transferred $475m of holdings in three funds – PRISA, managed by PGIM Real Estate, the JP Morgan Strategy Property Fund and the UBS Trumbull Property Fund – to the IDR Core Property Trust, a fund that is designed to track the ODCE index. CalSTRS has committed a further $400m the fund.

Investors that stuck with ODCE funds in 2020 and 2021 or committed new capital will not have been disappointed. Fast forward two years from the start of the pandemic and the ODCE index has enjoyed a record year of performance, returning 21% net of fees in 2021 – nearly three times the 7.7% average of the past five years.

The record year has capped a decade of strong growth for the ODCE market, which now stands at $321bn in gross assets under management. In 2010, there were 14 funds and today there are 27. Over that period, net assets under management have risen from $54bn to $268bn. “The bulk of the growth in the core fund market has come in the last 10 years,” says Dan Dierking, president of NCREIF. “New capital is also coming into the sector.”

But the ODCE sector is by no means without challenges. Even prior to COVID-19, many funds were striving to rebalance their portfolios, predominately away from a declining retail sector while ramping up exposure to industrial and residential markets, as well as expanding into alternative or niche sectors, including the burgeoning life-science real estate sector. The pandemic added more urgency to this trend.

Kevin White, global co-head of research and strategy for real estate at DWS, says: “COVID was disruptive to certain types of real estate, including retail properties occupied by local tenants forced to close during the pandemic. COVID also accelerated structural shifts across sectors and markets, creating winners and losers.”

The winners were principally industrial and residential, especially in Sun Belt markets, while the losers were malls, certain types of offices, and some big-city central business districts. “This translated into significant performance dispersion across ODCE funds, driven by underlying portfolio exposures,” White says.

Funds with heavy exposure to industrial and residential are likely to have outperformed. “In the last year, returns have exploded, particularly in the multifamily and industrial sectors – the latter seeing a 43% annual return,” Dierking says. “I’ve never seen numbers like this in all our 40-year history and it’s quite incredible.”

Could this reflect a shift in performance attribution in real estate more generally? Two years ago, MSCI analysed 94 global real estate portfolios and found that, on average, 70% of performance was attributable to the selection of individual assets (rather than sector weighting), but this was often higher during periods of market disruption.

Bryan Reid, executive director at MSCI, says: “During periods of crisis, asset selection has actually been even more important. Now, this seems to be changing, as divergence between sectors is so significant.”

As Reid says, “diversification has been overwhelmingly the attraction” of ODCE funds, as investors have sought “a broad spread of investments across the four major ‘food groups’ – retail, office, residential and industrial”.

Does diversification still work?

But does such performance dispersion between sectors call this rationale into question? 

Joe Cannon, executive vice-president of portfolio management at Bell Partners, which specialises in managing multifamily funds, says: “COVID created a natural acquisition and growth opportunity for funds that were well positioned with durable property types like multifamily/residential, industrial, and select niche sectors. Sector-specific or strategy-specific core funds have emerged as alternatives to the multi-strategy funds, which dominated the landscape 10 years ago.”

But White argues that the diversified approach still holds up and that it was diversification that meant the real estate “asset class as a whole proved resilient and delivered its strongest investment returns on record in 2021”. He says diversification offers “economies of scale in the construction, oversight and operation of real estate portfolios”.

Ann Cole, portfolio manager and global head of real estate client strategy at JP Morgan Asset Management, says: “ODCE funds continue to provide the foundational returns within plan sponsors’ real estate allocations. Real estate allocations should be built on a foundation of core/ODCE funds which then allows them to take more risk around this core foundation.”

New entrants frequently are concentrated in one subsector or geography or user type, don’t have staggered ‘user’ lease expirations, and may lack sufficient scale to achieve meaningful diversification. Managing an open-end core fund is not a job you can learn as you go. Investors should look for cycle-tested managers experienced in providing both routine and exceptional liquidity with trusted valuation protocols.”



As existing funds rebalance portfolios and new entrants skew the sector weightings, the make up of the ODCE index is expected to change, with retail and office taking up less of the benchmark in favour of industrial, residential and alternative property types.

NCREIF is also considering changes to its sector categorisation, which IPE Real Assets understands could including moving single-family and manufactured housing alongside multifamily into a new residential category, and creating a life-science subsector. “NCREIF is very responsive to the changing real estate landscape,” says Cole.

Ultimately, Reid says, the “climate for real estate managers is becoming more and more demanding as they adapt to a shifting landscape – not just in geopolitical terms but also the secular shifts, such as the rise of e-commerce and the work-from-home phenomenon”. And while the effects of the Ukraine crisis on the US real estate market have been minimal, “the impact of rising energy prices may be felt”, he says. “Stagflation is a different environment for the real estate class.”

Cannon agrees that there is “a lot of geopolitical risk in the world today, along with uncertainty around interest rates and inflation”. He says: “Some property types are more resilient than others in this type of environment. I expect continued growth in the [core funds] space as US private real estate continues to be increasingly accepted, and sought-after, as a preferred asset class globally.”

Cole is more optimistic. “We expect increased growth in flows to core real estate/ODCE as investors rethink their real estate allocations [and] as they evaluate their overall portfolio allocations,” she says. “Expected returns from equities and fixed income are going to remain under pressure over the… next 10 to 15 years. Investors need to increase their allocations to sectors such as real estate to generate their long-term target returns. As investors increase allocations to the asset class, a strong foundation in core ODCE funds will remain a critical element in providing yield, stability, and diversification in real estate portfolios.”

Cole adds: “The future of ODCE funds is bright as core real estate continues to deliver the income and diversification that investors seek. Additionally, many non-US investors are still in the early stages of building out their real estate portfolios, creating growth in future capital flows to the core real estate space.”

But is all as well as appears? Traditional commercial real estate is being disrupted by structural changes – e-commerce and working from home, for instance – and now the growing urgency to decarbonise what could become ‘stranded assets’.

Adriana de Alcantara, the fund manager of the recently launched Hines US Property Partners, says: “In my opinion traditional core is ageing as a sector and many of the assets are becoming obsolete. We need people to implement innovation and technology to transform the next generation of assets. Recent strong post-pandemic returns mask what is going on. Capex spending on office assets is going to be only defensive, which is a significant problem.”

Offices need to “provide sufficient amenities for tenants”, she says. “This is something that has become clear in response to the work-from-home phenomenon. And it’s only going to get worse.”

Core-plus equals the future?

The newly launched Hines US Property Partners is an open-ended fund, but unlike traditional ODCE funds it has a core-plus risk profile. 

Ann Cole

Ann Cole: “we expect increased growth in flows to core real estate/ODCE as investors rethink their real estate allocations”

“For me, the most exciting development has been the emergence of core-plus,” says fund manager Adriana de Alcantara. “The core-fund space is seeing three different kinds of funds emerging. The new core-plus fund such as our own, the traditional highly diversified core fund, and more active core funds which are somewhere between the two.”

The Hines fund has raised $1.4bn of equity, attracting not only US pension funds but European institutional investors, including the UK’s Greater Manchester Pension Fund. It has closed on six investments worth some $600m across industrial, multifamily, mixed-use and office sectors.

De Alcantara says there are three ways in which her core-plus fund is different. “Firstly, in portfolio construction: we are a core fund in terms of diversification and risk; 60% of the fund is traditional core, widely diversified assets; 20% is value-added – where we’re looking to improve the asset – and 20% is development. We blend all of these strategies to target core-plus returns of 9% to 11% net,” she says.

“Secondly, we seek to add value [with] a presence in 87 cities across the US. To be a truly diversified core fund investing across all the cities you have to know how to work the assets and have a presence in local markets. 

Adriana de Alcantara

Adriana de Alcantara: “the most exciting development has been the emergence of core-plus. The core fund space is seeing three different kinds of funds emerging”

Thirdly, we have a different approach to market selection. Instead of looking at traditional metropolitan markets which we feel are too large and diverse to present a consistent investment profile, we look at submarkets that score highly on our internal proprietary scoring system.” 

The Hines research team has developed a proprietary methodology that scores markets from zero to 100 (100 being the best score). “Selecting the right or wrong submarket means an over-400bps of difference in performance,” De Alcantara says.

Hines’s research has found that properties located in the ‘big five’ office markets (New York City, Los Angeles, Boston, San Francisco, and Washington, DC) have outperformed the ODCE index by 140bps since the year 2000. Submarkets within these big five with a score of more than 80 have outperformed by 200bps, while those scoring less than 20 have underperformed by 260bps. “The difference, therefore,  between top submarkets and poor submarkets is 460bps.”

European core real estate funds become more diverse