Be Happy With Second-Quartile Managers

It may seem counterintuitive, but managers and their investors should be happy with their funds being in the second quartile. At least that’s what the head of real estate at one U.S. corporate pension plan, faced with the task of balancing risk management and performance in their portfolio, told PrivcapRE. While GPs should strive to be in the top quartile, it shouldn’t be the “be all and end all,” he maintains. Funds in the second quartile can sometimes be safer bets. It all boils down to the use of IRRs as a measurement of manager performance, and how managers can manipulate their IRRs to achieve top-quartile rankings. Investors and managers know that successful realizations early in a fund help boost IRRs and, therefore, a fund’s quartile position. However, that ability to distort a track record also increases the chances that GPs will sell their best assets early to try and stay in the top quartile. Top-quartile performance also often equates to greater use of leverage and risk, meaning that being in the top quartile is very different from offering the best risk-adjusted performance. The real estate executive says when the next downturn happens, he doesn’t want to be “pushed into a corner,” forced to pay down maturing loans, or in need of a “cash sweep” and unable to cover tenant improvements to grow net operating income. “You don’t know what’s going to happen next,” he says, “so you can only manage risks based on the dispersion of outcomes you see today.” Leverage is one area where his pension is unwilling to compromise, insisting on below-market debt levels. That sometimes leaves the pension investing with second-quartile managers. And that, he says, is fine. The question of whether it’s good to have a manager in the top, second, or bottom quartile could be arbitrary without a focus on the persistence of a GP’s track record, says Greg MacKinnon, director of research at the Pension Real Estate Association (PREA). He has found some persistence in top- and bottom-quartile core real estate funds, he told PrivcapRE during a panel discussion on real estate performance. And there’s little evidence to support the belief that value-added and opportunistic fund managers perform less consistently than their core real estate peers. He adds: “The good performers tend to keep on being good, and the bottom tend to keep on being bottom. But when I’m talking about persistence, I’m not talking about any kind of guarantee.” And that is key. There’s no measure of performance that will provide you a bulletproof guide to investing in real estate and in real estate managers. Rather, investors need to understand what is driving the returns of each and every GP. How much of the IRR was driven by the use of leverage or growing NOI? Have investors asked for the trailing 12-month NOI figures? If risk is paramount to an investor, do they understand how a GP views risk in the fund and in the wider real estate market? And perhaps more critical is being comfortable with your judgment as an investor and not worrying about what could have been, once decisions have been made. If that decision results in a second-quartile manager, be happy with that choice, because it could be the best risk-adjusted choice for your plan.