The Art and Science of Real Estate Asset Allocation

In 2008, traditional allocation models were deemed a miserable failure, as the world watched asset values across the board collapse under the weight of the financial crisis. If there is one positive from the crisis, it is that it brought a greater focus on risk identification within portfolios, correlations within asset classes, and diversification. Today, that razor focus on asset allocation remains, especially for real estate. Yet in shaping asset allocation policies, there are few tools and models, and certainly no guaranteed formulas, available to those challenged with the task. “The financial crisis brought asset allocation to the forefront of everyone’s minds and made everyone think about what they could have done differently during a capital markets event and what warning systems they have in place for future events,” says Paige Mueller, managing director of consultant RCLCO. In thinking through their real estate portfolio and the risks within it, Mueller says investors can ask themselves a number of key questions that will help them better shape their asset allocation policies. Top-Down Analysis. From a top-down perspective, there are five fundamental factors that often shape an investor’s view on real estate opportunities, prior to any allocation analysis. The first is: what is the role of real estate, and what are the goals of an investor? That boils down to the expectations of real estate and the investor’s liabilities and obligations. For some investors, that means a cash flow orientation, while others look to total returns. Also, depending on an investor’s goals, real estate performance might be benchmarked to a variety of different factors, not least cross-asset class benchmarks as well as property type benchmarks. An investor’s goals therefore drive the second question: What are your limits? How much leverage fits the portfolio goals, and are there rules about housing real estate debt and equity? Are there prescribed ways to hold public and private real estate? Also, how far can a real estate allocation be decreased or increased? As Mueller says, “It’s about understanding the volatility parameters at the outset.” And size matters. The size of an investor portfolio, and the staff within that real estate department, dictates the third question: Should I invest directly or indirectly, or follow a combination of the two? “Everyone wants to have control over their portfolio, but to have control over decisions, you need to have staff and time to do it,” she says. The trend for control goes almost full circle back to the 1990s, when separate accounts were in fashion. “Investors then became concerned about diversification, and so the industry moved more towards the fund model,” says Mueller. “The tension of having control, investing directly, and having diversification—there has to be a balance between them all.” The tension is all the more apparent when large institutional investors are investing overseas. The act of investing overseas itself raises the fourth important question for constructing real estate asset allocation policies: What’s the right tax structure? Understanding your own tax structure in any given country, as well as those of your main competitors in that country, can dictate how investors play the real estate game, whether through debt, equity, or entity-level investments, as they seek to minimize the impact of tax and maximize cash flow and risk-adjusted returns. It is the fifth question, though, that presents the greatest challenge to investors in constructing more efficient—and potentially better performing asset allocation strategies: How do we address vintage year diversification? “Real estate is cyclical,” says Mueller, “and it pays to think about the impact of vintage and to structure your portfolio accordingly.” Few investors can run their real estate allocation down to zero, and for investors invested solely in closed-end funds the ability to liquidate in a timely fashion is extremely restricted. Mueller says it’s therefore wise to pay close attention to the supply-demand dynamics of real estate markets, the duration of leases within investor portfolios, and leverage on underlying assets. For instance, what’s the exit strategy, and does the leverage match the hold period, or will you need to refinance in three or five years when rates and liquidity might not be as favorable? Are they variable-rate loans? “You think a lot about cycles in real estate,” Mueller says. “What are you paying for those assets versus the replacement cost, and how much of your return is income or growth? To maximize risk-adjusted returns, you need to be able to reduce vintages in times where the forward risks are not justified and structure the portfolio to provide liquidity when needed.” Bottom-Up Analysis. So what about the real estate? After the top-down parameters are in place, Mueller says investors should think more in-depth about allocation models. “While there is no magic formula, investors can approach the task from a number of other angles, some top-down and some bottom-up,” Mueller says, citing a mix of historic performance and correlation analysis, risk budgeting, economic factor analysis, liquidity, and cash flow analyses, among many others. This is where investors and consultants take a detailed look at the opportunities and current market conditions and the existing portfolio and ask the question: How can a plan sponsor realistically achieve its goals over one, two, five, or 10 years? As Mueller says, “I want to understand how much the portfolio needs to grow, and how much of the existing portfolio is coming due, to create a transition plan for the overall portfolio that can realistically be implemented.” And this is where the science of asset allocation morphs increasingly into art. “Everyone would love to say there’s a perfect answer to asset allocations, but there isn’t,” adds Mueller. In setting asset allocation policies, though, it’s also important to factor in the need for some flexibility to respond to market conditions. Craft a real estate policy too narrowly, by specific property types, markets, and submarkets, and, as Sean Ruhmann, principal, private markets, at consultant NEPC says, asset allocations run the risk of becoming a beta play. “If you think about the two ways to generate excess return in a real estate portfolio, it’s about picking the right place to invest at the right time and then finding the right manager to do it with,” he says. “When you have fine allocations to office or apartment or whatever, you’re taking [one of those] off the table.” However, providing flexibility adds risk to a portfolio: “We think that level of risk is worthwhile. Otherwise, you’re just becoming closer and closer to a pure beta play, which I don’t think a lot of our clients want.” Ruhmann also argues the same need for flexibility when it comes to recommitting to fund managers. “In a perfect world, you would continually re-up with the same managers who generate consistent performance,” he says. “But I think you have to look at a manager every time they come around with a fund that they’re raising and make sure that the dynamics that looked attractive the first time around still exist—and those things do change over time.” Investors should therefore not be afraid of changing their GP relationships. In the end, the key to successful asset allocations is structure and flexibility. Following the financial crisis, investors need and want better frameworks for shaping their real estate portfolios, to be prepared for a capital markets event but also to help portfolios perform more efficiently across the cycles. In dealing with cycles, though, allowing room to maneuver is vital. As Mueller says, “Real estate is all about the cycle.” ■