The Golden Ticket

Real estate private equity managers are often innovative, supplying private capital in often-unique structures that get deals done and buildings built. But the next few years may present challenges that test the industry’s creativity—and its appetite for change.

One area in focus is their sources of capital. Managers need to attract capital from a wider range of sources, in particular from retail investors. That might not sound like much of a challenge. After all, strong retail demand for real estate in 2013 pushed inflows to non-traded equity REITs to a record level of $18.7 billion, double the amount raised in 2012. But non-traded REITS primarily tap retail assets through independent broker-dealers, a limited channel where high sales commissions and limited liquidity for investors’ holdings pose obstacles to reaching a broader retail market.

Most retail assets are held in accounts that are part of defined-contribution (DC) retirement plans. The opportunity is compelling. Assets in DC plans topped $5.1 trillion at the end of 2012, according to the Investment Company Institute, the trade group for mutual-fund companies. More than half – $2.9 trillion – was allocated to mutual funds, and real estate managers will have to find some way to provide investors with access to their expertise through this mainstream – and more highly regulated – vehicle.

For the past 30 years, private commercial real estate managers have “thrived,” managing assets from public plans and insurance companies, says George Pandaleon, president of Inland Institutional Capital Partners. Pandaleon believes defined-contribution assets are likely to grow substantially in the coming years and predicts that a switch from defined benefit to defined contribution in the public sector could occur much sooner – and faster – than many real estate managers expect. “Defined-contribution plans are going to be where the growth is,” he says. While the industry is still experimenting, he suggests that asset-allocation vehicles such as target date funds could enable CRE managers to tap meaningful retail flows.

Even a small shift toward DC plans in the public sector could result in large new cash flows. The 100 largest public plans in the U.S. had assets of $2.6 trillion in 2013, according to pension consultant Milliman, Inc. But those plans face liabilities of $3.77 trillion ($2.2 trillion for retirees and inactive plan members not yet collecting benefits and $1.6 trillion for plan members who are still working). That leaves the plans with only 27 percent of the assets needed to cover the accrued liability for active plan members. In states such as Illinois, underfunding of public pension plans has forced legislators to introduce 401(k)-style DC options for new, and some active, workers.

Pandaleon says CRE managers who can tap DC assets will hold a “golden ticket.” That will require innovation in product development and personnel. What’s needed, he says, is a product that can meet the need for the daily liquidity and daily pricing required in the 401(k) world. The next question is “how to get into the 401(k) option list.”

As a long-duration asset often involving private-market transactions, real estate does not readily lend itself to a daily-liquidity model. It’s a marketing dilemma, and CRE managers are in the early stages of experimenting with solutions. So far, no structure have emerged that meet the requirements of the major retail channels, DC plans, and fee-only financial advisers. It’s not for lack of effort on the part of private CRE managers, and the size of the retail opportunity means the industry will continue to try.

Approaches to date have clustered around three broad product-development strategies aimed at different parts of the retail-distribution spectrum. Those include hybrid funds that adjust sales loads and tweak other features of non-traded REITs in an effort to spur sales to a wider range of commission-driven advisers; mutual-fund approaches in which non-traded funds adopt pricing and other features usually found in registered fund vehicles in an effort to appeal to financial advisers who don’t sell commission products; institutional approaches that seek to deliver the performance of commingled real estate funds to defined-contribution plans.

Each approach has its merits, but tension remains between the retail channel’s need for liquidity and the inherent long-term nature of real estate. The most ambitious approach was Clarion Property Partners Trust, Inc. (CPPT). Launched in 2011 and liquidated in 2013, the fund received intensive industry scrutiny as a pioneering effort “to address well-known shortcomings associated with traditional non-listed REITs, principally, lack of liquidity, the rigidities implicit in a closed-end, finite-life, fixed-price investment, and high fees,” according to Clarion letters filed with the Securities and Exchange Commission.

To control costs, CPPT charged a management fee of 0.9 percent and a performance fee of 25 percent of gains that only applied after the manager, CPT Advisors LLC, a unit of ING Clarion Partners LLC, delivered a 6 percent minimum return. The maximum sales charge of 3 percent was significantly below the prevailing rate for non-traded real estate vehicles at the time. Despite the modest cost structure, the fund achieved little traction and reported only $13 million in net offering proceeds in its March 31, 2013 SEC filing. The fund was liquidated in June 2013. Clarion Partners LLC, the successor entity to ING Clarion, declined to comment for this article.

Perhaps the best illustration of the challenges facing CRE managers is the correspondence between CPPT and the SEC in early 2012, when the fund asked the SEC for permission to shift its redemption policy toward the “net redemption” policy used in retail mutual funds that offer investors the ability to redeem their entire position at NAV on any business day. Redemptions in CPPT were originally subject to a quarterly limit of 5 percent of the prior quarter-end net asset value. In 2012 the fund asked to revise its policy to set the 5 percent limit based on net redemptions in order to improve liquidity for investors. Redemption caps can prevent some investors from selling their positions if they try to redeem after the limit is reached. If not changed to a net basis, CPPT says, the cap “could limit redemptions in a quarter despite the Company receiving a net capital inflow for the quarter, which is at odds with the objectives of a perpetual life, non-listed REIT and does not advance the investor protection goals” of the SEC.

The rationale for the change highlighted the dilemma inherent in delivering the benefits of real estate investments to retail customers. Fund managers must hold cash to pay shareholders who redeem their holdings, but idle cash can hurt performance. CPPT says the change to net redemption was “designed to provide greater liquidity to the company’s stockholders without requiring the company to allocate a greater portion of its portfolio to cash, cash equivalents and other liquid assets that typically produce a lower return than investments in the company’s targeted assets.”

Another approach is being tried by The Blackstone Group, Inc., which in January filed with the SEC for permission to market a non-traded CRE vehicle, the Blackstone Real Estate Income Fund II. Blackstone declined to comment while the fund is in a quiet period. Blackstone’s structure appears aimed at intermediary firms and fee-only financial advisers; instead of a sales commission, the fund will pay an ongoing 12(b)-1 fee of 25 basis points, a flat annual marketing fee that is included as an operational expense in a traditional mutual fund’s expense ratio. The fund will have a 1.5 percent expense ratio and a 15 percent performance fee. While a marketing fee of just 0.25 percent seems razor thin in the non-traded REIT world, it shows the cost-sensitive nature of the retail channel.

One of the largest institutional real estate mangers, Prudential Real Estate Investment Management (PREI), has been pursuing the DC channel for about five years. Prudential is investing strategically in its effort. In 2011 it hired David Skinner, JP Morgan’s head of defined contribution investment only institutional sales, to spearhead its DC push. PREI’s website prominently features a video, “Commercial Real Estate in Your DC Plan,” and Skinner was instrumental in launching the Defined Contribution Real Estate Council (DCREC) during 2013. The group aims to persuade plan sponsors and consultants to add commercial real estate as a DC investment option.

On the investment front, PREI invests 75 percent of DC assets through a separate account in its institutional commingled funds to achieve exposure to the CRE asset class. To provide liquidity, PREI holds up to 25 percent in publicly-traded REITs and cash. That might cause concern in the DC world; in its video, PREI notes that REITS are not a good substitute for direct commercial real estate investments since REITs tend to track the equity market and trade like small-cap stocks, but does not address why assets with small-cap-equity characteristics are suitable as a cash equivalent. PREI did not provide a contact for this article. PREI clearly states that the ability to make daily withdrawals from its Prudential Retirement Real Estate Fund (PRREF) is not guaranteed, and redemptions could be delayed if the fund does not have sufficient cash available. While cautioning investors about potential illiquidity, PREI last year retained the Chicago-based Real Estate Research Corporation to determine the daily value of PRREF’s direct real estate investments and to ensure that the process is transparent, consistent, and accurate.

PREI notes that DC plans can access its direct CRE expertise through asset-allocation strategies such as target-date funds. Prudential’s strategy seems to be paying off. The fact sheet for PRREF shows assets of $468 million on September 30, 2013, although it does not indicate whether that is all from DC clients. And the Callan Glidepath 2020, a target-date fund designed for employee benefit plans and managed by the investment consulting firm, had a 12 percent allocation to PRREF on December 31, 2013—the fund’s second-largest allocation to a single manager of any strategy.