Real estate market segmentation offers a new route to returns.Steve Hays reports

Gaining a performance edge in real estate private equity - as real estate investment and the broader capital markets increasingly converge - demands a new, evolutionary approach to market segmentation, argues New York-based real estate investor Tommy Brown.Indeed, says Brown, he has co-launched a new private equity partnership with Joanne Douvas, Clerestory Capital Partners, precisely to take advantage of this shift in strategic real estate investing.
Brown observed that even as property investors have adopted tools from other asset classes such as securitisation and derivatives, the basis of portfolio construction has pretty much remained the same - and therein lies the opportunity.

"Capital today is losing its nationality," Brown says. "Globalisation is blurring national borders, and they are becoming less relevant for investment decisions. Against this backdrop, we are now looking at real estate globally in terms of a total-return strategy - so you can overweight managers, strategies or geographies to the extent they deliver superior performance."

Clerestory has been evaluating the non-listed fund-of-funds world, where, Brown says, most investors look at core and value-add strategies as a surrogate for direct real estate allocation. "They then organise their investments either with a geographic or a property-sector focus. But in the opportunistic space, funds are total-return-driven, and this is where we believe it is possible to adapt approaches from the broader capital markets to deliver what I would call ‘high-octane' returns."

INREV, the body representing Europe's non-listed real estate funds industry, defines opportunistic funds as those driven primarily through  capital returns. Their return targets are in excess of 18.5% a year net of fees and taxes, with capital leverage rates in excess of 70% of gross asset value.

Brown believes investment vehicles of different sizes, including real estate funds, generally have different investment characteristics. Accordingly, when evaluating opportunistic funds, Clerestory divides them into either large cap (more than $1bn (€700m) of assets under management) or small cap (under $1bn) pools.

"It's part of our evolving philosophy that the old methods for subdividing real estate opportunities are gradually becoming less relevant," he said.

In a recent research study, Clerestory calculated that there are currently 197 opportunity funds actively investing globally. Within this universe, there are 71 small cap funds, either in the market or soon to be, seeking to raise approximately $30bn of equity; and 17 large-cap funds aiming to raise $64bn.

"Historically, the large cap managers used to be small caps," Brown says. "They've now grown to a size - with the largest reaching $10bn in total equity - that allows the big institutional investors to invest, say, $200-400m at a time and maintain what I'd call a ‘beta exposure' to an opportunistic or total investment return."

Small cap opportunity funds are perceived to be more entrepreneurial and "hands-on" in executing their strategies than bigger funds. They are more focused on specific property types; and, from an emerging markets perspective, they have direct access to key local players. This all suggests they can provide superior returns, Brown explains.
He admits that this strategy is in its early days: "There hasn't been an empirical study done in the real estate market to compare the relative performance of small cap and large cap funds. But in the private equity world, statistics suggest that smaller managers can outperform bigger ones. We just haven't proved it in property yet."

Clerestory believes the critical factors in underwriting any real estate fund are its sponsorship, strategy and structure. In the opportunistic world this means fund managers have a mindset not only to make money, but also to manage risk and focus on value, control and exit - regardless of the size of their funds.

Although concerns are rising over real estate investments broadly, in an environment of rising interest rates and bond yields, Brown says now could be an ideal time to turn towards opportunity funds, even if the markets do take a dive.

"Opportunity funds make money in times of distress, and their hallmark is finding undervalued assets, or pockets of value, in up or down markets," Brown believes. "It ultimately comes down to manager selection and understanding the risks."

Brown and his colleagues at Clerestory anticipate a continued confluence of capital between traditional real estate investors and capital markets investors - such as hedge funds and high-net-worth individuals - as all market participants chase returns. The result: evolving approaches and segmentations that reflect the new reality of real estate's place within broader asset management trends.

Brown says this new approach is already in evidence: "Taking into account relative risk, people are now more focused on how individual investments stack up against each other on a total-return basis, rather than in terms of equities or bonds or alternative investments."

Steve Hays is a founding director of Bellier Financial based in Amsterdam