How to find your centre in the rush for real estate returns.

There are various reasons why many plan sponsors include real estate in their asset allocation models. The improved transparency of this asset class, along with an established and credible performance index, has given it a more prominent place on the shelf of investment choices. In addition, there are now more vehicles and offerings through which plan sponsors can choose to gain exposure to real estate.

While all these reasons are valid and guided by prudent investment practices, the main impetus to invest in real estate has been the eternal quest for portfolio return. Plan sponsors need greater returns from their assets to fund the ever-growing liabilities of their plans, and to keep up with the investment performance benchmarks of their peer groups. Add to this the increasing payout portion of these plans as the baby boomers retire and draw down pensions and real estate becomes an even more attractive investment choice—not only providing good returns, but also delivering most of those returns by way of regular dividends.

Real Estate 101

There are a number of ways for plan sponsors to get in the real estate game. Real estate assets can be owned directly, through partnerships, or through closed-end funds, to name but a few of the available options. These choices have a significant impact, and performance ranges will vary based on these initial decisions. Assuming that the method of attaining exposure is optimized, what can plan sponsors do next to enable higher-than-average returns from this asset class?

Real estate is a fairly recent addition to pension plan investment portfolios and has some unique characteristics compared to the more traditional bonds and equities. While market timing is similar and performance points can be won or lost depending on when purchases and sales are executed, investment managers have little or no impact on the performance of bonds or equities during their holding periods. By contrast, real estate is a living and breathing asset, and investment decisions must be made regularly during its holding period. For example: What should the leasing rates be for vacant space in the building? How much of a capital expenditure program should there be, and what is an appropriate schedule for these investments? What are the operating costs in the building, and what can be done to keep them competitive compared to other buildings? Should existing tenants be renewed early, and what kinds of incentives should they be offered? Have the market threats against the cash flow of the building been properly assessed, and what is the best strategy to counter them?

These are just a few of the many questions that need to be answered. Investors must ensure that they have the necessary resources to understand the market thoroughly and be able to sift through the annual real estate budget, the day-to-day leasing activity and the expenditure program in order to make the right decisions. The outcome of these decisions will help deliver the highest possible return from the property, with the least risk.

Keep an Eye on the Issues

When investing in real estate, there are some key issues that investors must not neglect. For example, they must be able to review a property’s annual budget and knowledgeably challenge the operating expenses, leasing assumptions and capital expenditure program. The owners must have access to buy-sell expertise and thus, be in a position to develop an exit strategy for any given asset. It’s also important to develop strategic plans for both the portfolio and the individual assets.

Property owners must also have access to extensive expertise on the type of assets to be managed. Office, industrial and retail properties each have their own set of unique characteristics and challenges, and their owners need a solid grasp of local market conditions, as well as the property’s strengths and weaknesses. This knowledge should also be helpful in deciding which third-party service providers are best equipped to execute the asset strategy and the appropriate level of fees.

How are plan sponsors dealing with the multitude of issues involved in owning real estate? Some have hired the required expertise, building their own qualified staff to oversee the assets. A minimum portfolio size of $1 billion is usually necessary to justify gearing up internal staff, since it can be difficult to attract resources for smaller portfolios. Others try to align themselves in mutually beneficial ownership partnerships, which can eliminate the need for additional oversight. Even some plan sponsors with large portfolios mixing both direct ownership positions and partnerships have turned to outsourced asset management services to minimize internal overhead and to maintain maximum control and supervision over their investments.

Beating the Cycle

Which type of arrangement works best, and which delivers the best alpha on plan sponsors’ assets? While there is no quantitative data available to answer this question, plan sponsors have a duty to take a close look at their newly acquired real estate assets and get the necessary expertise to make them perform optimally. Real estate assets can be made to work harder than other asset types and can deliver above-average performance.

Like other markets, the real estate market is cyclical and has done well over the last few years by moving from the recovery through to expansion phases. While the market will eventually reach the inevitable contraction and recession stages, plan sponsors that understand the issues and expertise required—and that can tailor the oversight of their assets accordingly—will benefit from above-average returns, regardless of where we are in the real estate cycle.

Reflecting on Real Estate

Looking to take the real estate plunge? Here are some important factors to consider when making your decision.

Annual Budget Approval
• What are the leasing rates?
• What operating expenses should you plan for?
• How much capital will you need to invest in the building(s)?

Leasing Options
• What are the asking rates?
• Are there any tenant incentives offered?
• If so, what types of incentives (e.g., free rent, monetary compensation) and at what amounts?

Capital Expenditure
• Which items will be included in your capital expenditure?
• What’s your strategy for handling these expenses?
• How will these expenses be recovered from the tenants?
• What impact does your plan have on gross occupancy costs for the tenants?

Exit Strategy
• What’s your timing for selling the asset?
• What tactics will you use to maximize the sale price?

 

Marc Gaudette is vice-president at Murray & Company Real Estate Advisors Inc. mgaudette@murraycie.com

For a PDF of this article, click here.

© Copyright 2008 Rogers Publishing Ltd. This article first appeared in the Spring 2008 edition of INNOVATE magazine, published by BENEFITS CANADA.

 

Copyright © 2020 Transcontinental Media G.P. Originally published on benefitscanada.com

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