It’s a core, core world

Every January, members of INREV come out of the cold and gather for good drink, good food, good company and more than a little good information as the unlisted fund group releases its Investment Intentions survey at its annual U.K. Winter Seminar. This year, results of the survey yielded few surprises — investors want core and more core — and even fewer credible investment options.

Joe Valente, head of research and strategy at J.P. Morgan Asset Management’s Global Real Assets, presented a quick market overview before launching into some of the survey highlights. He noted that heightened volatility will continue, but volatility is actually good for real estate.

Consensus on pricing has disappeared — some see a promise of rental growth just below the surface while others see nothing of the kind. Pricing will move in different directions depending on where you sit on the risk spectrum. With all of this uncertainty, investors are looking for safety.

“Everybody wants core because core is defensive,” he said, “but is core at 3 percent to 4 percent truly defensive? Where do we draw the line?”

Although the overall Investment Intentions survey conclusions pretty much just confirm what everyone already knows, the details provide color to an otherwise bland landscape.

On the positive side, 40 percent of investors intend to increase their allocation to real estate across Europe. On the down side, nearly 70 percent primarily want core products, with 50 percent of investors expecting to increase their allocation to core during the next two years. In fact, more than 90 percent of Dutch investors are focused on core. “That verges on obsession,” commented Valente.

In a reversal from past surveys where investors were open to diversified funds and investments, they now prefer single-sector, single-country, closed-end, seeded, regulated funds. Seems the grass is always greener on the other side.

For the past couple of years, Institutional Real Estate, Inc. has been asking investors and managers a series of questions and comparing results. Inevitably, there is a divergence on what investors think and what managers think investors think. The INREV study provides further evidence that investors and managers are often on different pages. For example, 80 percent of investors want to be active in the funds they invest in (“The other 20 percent deserve what they get,” cracked Valente), but only 60 percent of managers think investors want to be active. In another area, only 5 percent of investors want to increase their exposure to the U.K. market, but 20 percent of managers want to increase exposure.

When it comes to alternative investments, investors don’t give a hoot about derivatives (0 percent said they planned to invest), but debt funds and infrastructure are gaining in popularity. Real estate debt funds are the most popular mandate among the alternatives investments for investors and fund of funds managers, followed by infrastructure. Around 27 percent of investors have already invested in debt funds and infrastructure, a figure that is slightly higher for fund of funds managers at 31 percent. During the next two years, around 41 percent of investors said they are likely or very likely to make an investment in

real estate debt funds compared with 23 percent a year ago. Investors show a real interest in infrastructure, but there is very little product to allow them to act on that interest.

A few other interesting tidbits:

  • 80 percent of investors want to be with like-minded and like-domiciled investors, the exception being the Dutch who, for some odd reason, prefer to invest with non-Dutch investors.
  • 64 percent of respondents like German retail, making it the most preferred investment. Is it because we all know those wild and crazy Germans love to spend their money in shopping centers?
  • When choosing a manager, investors look first to track record and then style and platform. Fee structure is well down the list.

The panel that followed Valente’s presentation dove into the findings and added some meat to the bones.

Neil Harris, senior vice president and head of asset management, Europe, at GIC Real Estate, noted that fees were important, but they come after track record and style. Instead of focusing on how fees are structured, he prefers to look at how the funds are structured.

“We’d like better monitoring of risk, more visibility and fewer blind pools,” he explained.

Of course, fees aren’t completely ignored. “We prefer to pay fees when value is realized, not service being provided,” he said — a statement that was greeted by heads nodding in agreement throughout the crowd.

During the discussion, it was suggested that real estate can sometimes find itself too insulated in its thinking. When managers are pitching a product, they aren’t just competing against other real estate managers, they are competing against other asset classes. “We don’t often interact with an institutional investor’s CIO,” said Adam Calman, principal and head of Europe at The Townsend Group, “but that is who is looking across all asset classes and deciding how much to allocate to each. Real estate has yield to persuade a higher allocation, but we have to know how to make that argument.”

He suggested participants go to the Teachers Retirement System of Texas website and look at the matrix of asset class returns found within their monthly performance reports to see how real estate has ranked in comparison to other classes during the past 20 years for one major investor — and to get an idea of the range of investments available for a CIO to choose among. There’s a whole lot more out there than stocks and bonds.

Finally, Jeff Jacobson, CEO at LaSalle Investment Management, pretty much summed things up when he stated, “Europe was rough last year — and getting rougher.”

My guess is we’ll be saying the same thing in January 2013, just as we did in January 2011.

Sheila Hopkins is managing director – Europe at Institutional Real Estate, Inc.


Investors increasingly seem focused on fees. And in some cases, concern is warranted. Is it really necessary to pay 200 basis points and 20 percent over an 8 to manage multibillion-dollar pools of capital that are then heavily leveraged to drive up risk and return, when the manager has relatively little real capital at risk on a proportionate basis as is often the case with private equity and venture capital type investments?

Downturns like the one we experienced in the early 1990s and late 2000s also can get investors looking at costs, and on a superficial basis, real estate fees do seem to be disproportionately large when you’re looking at total fees paid relative to total assets managed.

If you looked at the annual report of the California Public Employees’ Retirement System (CalPERS), for example, you’d see that of the total fees paid out to managers, a disproportionately large percentage of those fees are paid out to its real estate investment managers, which manage less than 8 percent of its total assets.

Equity investment management fees typically range between 20 basis points and 50 basis points on assets under management, depending on the management intensity of the mandate. Fixed-income investment management fees typically are even lower. Real estate investment management fees can range between 50 basis points and 150 basis points on assets under management — or more. In good times, incentive fees can drive the average fee over the holding period up to as much as 150 basis points to 200 basis points or higher.

What’s missing in the comparison is what’s embedded in the cash flows derived from equity or fixed-income investment management. The source of those cash flows, just as with real estate, is the net operating profits of the businesses in which those managers are invested. All businesses must be managed, and the costs of management shows up in the labor burden embedded in the company’s profit and loss statement.

Take CalPERS, for example. According to its 2010 annual report, real estate fees in 2010 accounted for roughly $185.162 million before incentive fees, which, on total real estate assets under management of approximately $13.2 billion, was equivalent to roughly 1.41 percent of assets under management. After incentives were taken into account, real estate fees for 2010 equated to roughly 1.48 percent of real estate assets under management. This might sound high when you compare it on a relative basis with the cost of managing an equities or fixed-income portfolio. But is it?

The returns generated on a current cash yield basis from managing an equities portfolio already account for the labor burden required to pay the people who actually manage the businesses from which those net returns are derived. Not so in real estate. The cost of managing the operating businesses (and each property in a portfolio is, indeed, a separate operating business) is external to the cash flows generated by the portfolio. It’s an add-on cost.

If you assumed that 32 percent of the fees paid to a typical real estate investment manager reflect these direct labor costs, then the true fee for managing this portfolio would have been less than 100 basis points. Given the management intensity of the asset class, that doesn’t appear to be too out of line. And most real estate investment management concerns would be hard pressed to operate their investment management operations by allocating just 32 percent to labor burden. For some, the labor costs associated with running these kinds of enterprises can be as high as 60 percent of fees or even higher, and at 60 percent of fees, the actual management fees would be closer to 0.56 percent of assets under management — much more competitive when compared with the fees charged by equities managers on a more apples-to-apples basis.

The assumption underlying the current trend toward placing downward pressure on real estate investment management fees seems to be that managers are overpaid. The above analysis might support that argument, but if so, only by a very thin margin.

The problem you as investors have to come to grips with is that managers, like you, are in business to generate a profit. If you continue to shave their fees, the only way they can preserve their margins is to reduce their costs. And the most impactful way to accomplish this is by reducing the quality of the kinds of people they can afford to attract. Doing that, you have to admit, is not what you ultimately want them to do.

I realize it’s not comforting to most of you to hear the argument that managers already have suffered fee reductions through the reduction in the value of their assets under management. But the fact of the matter is, they have. If you pressure them to cut even further when their revenue base already has been severely undermined, you are asking them to cut way past the flesh, way beyond the meat, right into the bone. And that can have decidedly unfavorable unanticipated consequences for the management of your portfolios.

It’s certainly within your rights to attempt to get the best deal in the market. And there’s no reason you should be expected to pay more than you need to, in order to attract the best talent. But beware, there are traps embedded in pushing that line of thinking too far.

When you squeeze managers too hard on fees, only the largest managers will be able to afford to bid for your business. There’s nothing wrong with that, I would suppose, but some managers may find themselves willing to compete for this kind of business at a loss, in hopes of securing market share and a relationship they hope, in the long run, can be convinced to loosen up on fees and start to generate a more profitable result. Do you really want your managers to be bidding to take on your business at a loss? If you think about the implications of doing this, I think the answer to the question will become quite obvious.

Some consultants also seem to have developed a specialty in helping their clients pound manager fees down. This certainly is a way to demonstrate added value in the short run. If I were you as an investor, however, I’d look more to the consultant’s track record in recommending managers and investment programs that perform, rather than merely focusing on the consultant’s ability to pare back fees. After all, you have to fund programs with after-fee returns. And if the returns aren’t there, it really doesn’t matter much how much money you saved in fees.

Some of you seem intent on paying managers flat fees only sufficient to cover their costs. This also is a mistake. As the late management guru Peter Drucker once pointed out, profits are the cost of staying in business. If you want managers with staying power, you want to make sure that the business of managing your money is profitable in itself. Then, if you want to add in incentives to focus those managers’ attentions, make sure it’s a bonus and not the only source of staying in business. Otherwise, when markets turn, you may find that all you have really accomplished is undermining your ability to maintain control over a tumultuous, highly challenging and dangerous situation.

What all of this means, of course, is dealing with the fee issues isn’t easy. By all means, do whatever you can to make sure you get a fair deal. But you have to be careful. I’d caution all of you to be very careful. After all, it’s a whacky world out there!

Geoffrey Dohrmann is president and CEO of Institutional Real Estate, Inc.