Over the past 20 years, as real estate has come to be an accepted part of a diversified institutional investment portfolio, strategies for investment in real estate have expanded across the entire risk/return spectrum. Investment options now range from low risk/low volatility strategies, some of which offer almost bond-type characteristics, to higher-risk strategies with characteristics more akin to those of venture capital or traditional private equity investing. It has become common for these strategies to be categorised generically as “core,” “core-plus” (or “value-added”) or “opportunistic,” depending upon general notions of their relative risk.
The chart below illustrates the relative position of various “generic” equity investment strategies along a spectrum of risk and return, assuming each strategy is executed under similar property and capital market conditions. It is important, however, to keep in mind that factors such as market selection, property type and asset quality are critical to a risk/return analysis.
A core investment strategy is by definition low-risk. Core investors tend to take a very long-term approach toward real estate investment, viewing real estate as a bond-substitute with some diversification and inflation hedging characteristics. They generally do not view real estate as a way to maximise returns. In the property markets, core strategies generally encompass the direct ownership of high-quality, fully leased assets located in primary markets that are well diversified economically and that offer significant liquidity. These cities are usually global business hubs or national capital cities, such as London or Paris. It is expected that much of the investor’s return from core investment will come from a stable level of current cash flow, with capital appreciation contributing only modestly to overall performance. Typically core strategies are not financially engineered, using only small amounts of leverage, if any.
In Europe, core investment strategies are commonly executed by institutions and a small group of high net worth international investors operating in their domestic markets. The supply of core capital in plentiful and true core opportunities tend to trade at relatively low capitalisation rates. In most European office markets, for example, typical cap rates for high-quality core properties average 6% and average total returns are between 7% and 9% over a 5- to 7-year time horizon.
Generally, the level of management intensity required for core investment assets is relatively low. Consequently, European investors who are comfortable with the market cycle and their ability to harvest their investments are likely to execute core strategies directly, without commingled investment vehicles, local operating partners, or incentivised investment managers with local platforms. That said, market practices are becoming much more flexible and fundamental real estate research is becoming a critical part of the investment process. In this environment it is increasingly common to see a core strategy being implemented by a research-driven, incentivised manager. In today’s European market, good quality research is not widely available to investors and it is necessary to triangulate multiple sources of information. Access to local “street-level” intelligence is a key competitive advantage.
Opportunistic real estate investing is at the other end of the risk/return spectrum. Opportunistic strategies burgeoned in the mid-1990s as many investors sought to capitalise on the collapse of global real estate markets by acquiring distressed assets being jettisoned by banks and other financial institutions. The strategy has now matured to include financing of real estate operating companies, acquisition of non-traditional or speciality property types, development transactions, participation in corporate outsourcing, arbitraging of pricing differentials between public and private market opportunities, and highly leveraged net lease transactions.
Opportunistic real estate is a return-driven investment strategy, with capital flowing to markets and opportunities offering the highest available returns. Targeted returns are typically in excess of 20%, with little if any current income in the early years of the investment. Opportunistic investors have a high tolerance for risk, limited diversification requirements and a much shorter time horizon than core investors, with anticipated holding periods generally in the range of three to five years.
Core-plus strategies lie between core and opportunistic on the risk/return spectrum. These strategies are typically associated with moderate leverage, value-added management (such as redevelopment or re-tenanting), some sharing of ownership as through a joint venture or partnership, or alternative real estate investments such as listed securities. A proto-typical core-plus investment would be the acquisition of an under-managed, multi-tenant office building in a major metropolitan market, utilising moderate leverage (around 50%), with the objective of renovating and re-leasing the building and ultimately achieving a total IRR in the mid-teens.
Core-plus is undoubtedly the most flexible approach to investment as it can be diversified or product focused; it can involve direct assets or securities; it can be executed via commingled funds or separate accounts; and, with appropriate structuring, it can encompass a much broader range of assets than a typical core portfolio. Its
inherent flexibility makes this type of strategy ideally suited to investors seeking a balance of diversification, return premium and control. As a result, it is gaining in popularity among US investors who are looking at Europe, but also by European institutions seeking to enhance diversification by investing outside their domestic borders. Indeed, several European institutions are currently backing investment funds as a way to gain exposure and experience outside their domestic markets.
Commingled funds remain the preferred vehicle. Most investors are in the very early stages of constructing a diversification strategy that includes non-domestic investment, and the amounts of capital being committed are relatively small. Both of these factors favour commingled accounts. As is the case with any strategy, a commingled core-plus approach generally results in higher management charges and back-end performance incentives to align manager and investor interests.
Despite some increased popularity, core-plus capital is still not widely available in most European markets. Historically, this tranche of risk capital has come from local entrepreneurial real estate operators, with finance provided by local lenders. However, the internationalisation of banking activity, coupled with the hangover that many smaller lenders still have from the last real estate cycle, has limited the flow of such financing. Opportunistic investors remain largely uninterested in these opportunities because of their relatively small size and mid-teens return potential. At the same time, there continues to be a steady supply of core-plus opportunities arising from the internationalisation of Europe, the introduction of the Euro and related corporate and economic restructuring.
This combination of factors leads us to believe that core-plus strategies currently offer the best risk/reward opportunity for investors considering European real estate. There are a growing number of core-plus opportunities, with relatively little available capital; the size of most core-plus opportunities is small enough to allow many investors to achieve modest diversification (particularly through a fund vehicle); and most European markets have sufficient size and depth to attract increasing amounts of capital, thus allowing for adequate liquidity and exit options.
The execution of a core-plus strategy is more complex and management-intensive than a core strategy. Consequently, it is important to have an established local presence – including management, research and market intelligence – in multiple markets.
Simon Martin is executive director at Curzon Global Partners in London
