LP Perspectives. Real Estate Obsolescence: Portfolio Risks and Opportunities

Transcription

1 LP Perspectives Real Estate Obsolescence: Portfolio Risks and Opportunities Institutional investors discuss real estate obsolescence and its impact on portfolio strategies and manager selection

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3 Four Principles of Obsolescence and Portfolio Construction Institutional investors are no strangers to the threat that obsolescence can pose to real estate portfolios. Obsolescence is a key thesis behind repositioning strategies across the value-add and opportunistic spectrum, and demands thoughtful acquisition, execution and disposition strategies across all risk spectrums to help mitigate its occurrence. Yet, in today s disruptive digital era, obsolescence feels more present and more of a threat than ever before. But what do institutional investors think? How are investors approaching the challenge of real estate obsolescence whether economic, functional or technological and, most importantly, how is it impacting their portfolio construction and allocation strategies, and how they underwrite their investment partners? 3 LP Perspective: Real Estate Obsolescence, Portfolio Risks and Opportunities, Q1 2018

4 During one-on-one interviews with U.S., European and Latin American public and private pensions, consultants, multimanagers and family offices, investors tell Shelter Rock that there is no right answer to the question of mitigating obsolescence. Some LPs believe all property types are at risk due to obsolescence fueled by technological advances and changing consumer preferences. Others are extremely concerned with economic obsolescence: property types unable to grow asking rents irrespective of cap-ex increases. Several investors point to the evolution and cycle of buildings, saying commercial real estate is not a static, bond-like, asset class that remains the same over the duration of a 20- or 30-year-hold but is regularly in a state of renaissance and reinvention. All investors and consultants agree that adaptability and agility are key characteristics to look for, and underwrite, in future investment management partnerships as LPs and GPs face the changes to come. What follows are four key takeaways from our conversations: Four Principles: 1 Obsolescence or Evolution? 2 GP Agility 3 Understanding Exposures 4 Scale and Influence LP Perspective: Real Estate Obsolescence, Portfolio Risks and Opportunities, Q

5 1 Obsolescence or Evolution? It s easy to define commercial real estate obsolescence. Functional obsolescence is the inability of a property improvement to perform the job for which it is designed, while economic obsolescence is the loss in value due to factors outside the property itself. Investors face a much more daunting challenge than merely defining obsolescence. They need to understand whether the disruption being caused in commercial real estate by technology, demographics and changing preferences is affecting a property s (or a property type s) very existence or whether it s part of the natural evolution of real estate and something that can be cured. Offices with huge cores Apartments with eight-foot ceilings There are some things that can t be fixed. For one European multimanager (>$1bn real estate assets under advisement), all property types face an element of functional obsolescence thanks to rapid advancements in technology, not least in robotics, and corresponding changes in consumer preferences. Offices with huge cores are obsolete in a creative office environment, the multimanager says. There s going to be a series of two malls in every major city, at most, that survive. Apartments built in the 1970s and 1980s with eight-foot ceiling heights There are some things that can t be fixed. Well-located parcels of land will always have value. The managing director of one U.S. private pension (>$1bn real estate portfolio) concedes there is no right answer to the question of obsolescence and how LPs should respond, but that the word itself is provocative. You have to try to separate [the signal from] the noise, the private pension managing director says. The one thing I keep thinking is that well-located parcels of land will always have value. This sentiment is echoed by a U.S. public pension senior real estate investment officer (>$5bn real estate portfolio) who says that, while obsolescence is an issue, the institutional market today faces an adaptive re-use challenge. 5 LP Perspective: Real Estate Obsolescence, Portfolio Risks and Opportunities, Q1 2018

6 For us, if you re buying the right dirt, it s about adaptive re-use and recognizing that creative energies need to be applied to ensure the property is always viable, the investment officer says. However, it is economic rather than functional obsolescence that is the biggest concern for the managing director of a European public pension (>$20bn real estate portfolio). With institutional investors typically buying recent vintage or better located assets, you can generally put the capital in to cure the physical [or functional] obsolescence, says the European managing director. But there are some property types in many markets, that face rents or net rents that haven t moved in a decade or two. In an inflationary environment, you have to be able to increase your rent because you cannot count on cap rates continuing to contract, the managing director adds. As one global consultant (>$75bn real estate assets under advisement) stresses, real estate isn t a static asset class. Office space is constantly evolving; retail space is constantly evolving. Preferences for industrial space and apartments are shifting, the consultant says. Real estate is not a bond and you shouldn t have a [U.S.] Treasury mindset [when investing in it]. 2 GP Agility Investors may be split on whether to define the disruptive trends currently impacting commercial real estate as obsolescence or renaissance, but they are in agreement when it comes to the solution: successful investing requires GPs to have the flexibility and agility to adapt to changing demands. What really creates physical obsolescence outside of just traditional cap-ex, is [failing to] ensure you create the right experience for your tenants, says the managing director of the European public pension. LP Perspective: Real Estate Obsolescence, Portfolio Risks and Opportunities, Q

7 In order to create the right experience, investors say, investment managers need to truly understand their clients, including tenants and LPs. It s all about knowing your customer, the head of real estate at a Latin America family office (<$1bn real estate portfolio) explains. When you look and understand what the changing customer or renter profile looks like, there s much more demand for amenities, lifestyle and service. [The challenge is] how you distinguish yourself as a brand, as a product I think that s really critical. The managing director of the U.S. private pension agrees, saying GPs need to be plugged in and constantly checking in with customers, which should include tenants, brokers, buyers and LPs. It causes people to think about how to be adaptable. Is the manager set in their ways or are they able to adapt as things go forward? Quantifying manager flexibility, agility or adaptability is not an easy task. However, several investors and consultants suggest ways to enhance manager due diligence, including: Assessing the GP value creation process and the ability of GPs to reposition assets; Asking GPs to underwrite the impact of new technologies on assets and the subsequent different sources and uses for the properties; Challenging GPs on deals that didn t hit baseline assumptions and turnaround business plans; Asking GPs about the early warnings signs that signal whether to exit a deal. For some investors, part of the solution is to commit to vertically integrated operators or firms with strong operational and asset management capabilities. For others, there is a hung jury between allocators and operators. Irrespective of the GP model, LPs say it is essential for GPs to have strong relationships with tenants and vendors, as well as creative service firms such as architectural and fit-out specialists. It is about keeping abreast of constant change, says the U.S. public pension senior real estate investment officer. It s about being flexible enough and having the groups that can help you change an asset as needed, especially if tenant demand is moving along a different path than what you first envisioned. One U.S. consultant also advises LPs to do their own research and take nothing for granted. Talk to as many different people as you can and get as many different perspectives as you can, the consultant (>$50bn real estate assets under advisement) recommends, to help investors understand emerging real estate and property-use trends. 7 LP Perspective: Real Estate Obsolescence, Portfolio Risks and Opportunities, Q1 2018

8 3 Understanding Exposures We may live in a world of on-demand information, but for many institutional investors investing in private real estate it remains a challenge to understand their own portfolio exposures, including current holdings at risk of obsolescence. You can t manage a risk if you don t even know what you own, and you may be surprised at what you own, says another U.S. consultant (<$50bn real estate AUA). It starts with absolutely having the necessary information to actually understand what you have [in an effort to mitigate obsolescence risks], adds the U.S. consultant (>$50bn real estate AUA). It is a problem openly discussed by LPs themselves. You ve hit a sore point in the pension industry, says the senior real estate investment officer of the U.S. public pension, who receives up to 100 financial reports each quarter and is unable to slice and dice the data and aggregate it as desired at a portfolio level. We re driving a Model T that s got 80-yearold technology. The GPs have moved up to Ford Fiestas. Meanwhile, there s Tesla s running around out there in other sectors. LPs do not have the transparency of portfolios to truly assess risk on a granular level, adds the real estate investment officer. But [real estate technology is in] its early days and I would almost guarantee that technology will disrupt the LP side too and within 10 years we will be able to do that. LP Perspective: Real Estate Obsolescence, Portfolio Risks and Opportunities, Q

9 We re driving a Model T that s got 80-year-old technology. The GPs have moved up to Ford Fiestas; meanwhile, there s Tesla s running around out there in other sectors. Despite the lack of technology, LPs can tap existing resources within their own institutions to improve their understanding of risk exposures not least from fixed income, and public and private equities colleagues. The former head of real estate at a U.S. private pension (>$5bn real estate portfolio) says they worked regularly with equities and bond teams to understand tenant and macro risks to better understand the exposures within the real estate portfolio. Internal research, particularly market, sub-market and asset tours, are also important in understanding portfolio risk. You should also understand what the competition [and other managers are] doing, says the managing director of the European public pension. [You should understand if you and your GP are] ahead or behind, or just doing things differently. 4 Scale and Influence While not all interviewees call for consolidating the number of GP relationships, some investors say they want strategic relationships with managers that provide them with scale and a voice at the table. What I like to think about now, and what s important to us, is scale and skill, says the managing director of the European public pension. Real estate is becoming a scale business that ultimately affects an organization s skill set, the managing director says. The more you see, the more you can do, the more you understand how things are evolving and how they re changing. For the European multimanager, the key to fewer manager relationships is having control over which deals they do at any given time. For LPs unable to invest deal-by-deal, the multimanager says strategic partnerships where you can put out a decent amount of capital and have a voice at the table are favorable in today s market. 9 LP Perspective: Real Estate Obsolescence, Portfolio Risks and Opportunities, Q1 2018

10 Note to Readers: LP Perspectives: Real Estate Obsolescence, Portfolio Risks and Opportunities is the third in a series of publications to be produced by Shelter Rock Capital Advisors LLC providing institutional investor insights into the private equity real estate investment management business. The report reflects the views of individual LPs and consultants who were personally interviewed by Shelter Rock during the course of the fourth quarter Shelter Rock conducted face-to-face and telephone interviews with nine U.S., European and Latin American institutional investors and consultants to gauge their perspectives on real estate obsolescence and the impact of economic, functional and technological obsolescence on portfolio construction and allocation strategies. Interviewees represented a wide range of investors, including one U.S. public pension investor (>$5bn RE AUM); one current and one former U.S. private pension investors (from >$1bn to <$5bn RE AUM); one European public pension investor (>$20bn RE AUM); one European multimanager (>$1bn RE AUA); one Latin American family office (<$1bn RE AUM); and three current and former U.S. and global consultants (from <$50bn to >$100bn RE AUA). Real estate portfolio values were calculated in U.S. dollars as of January 1, 2018, with information sourced from investor websites, investor materials and Preqin. Throughout the report, the views of investors and consultants have been represented as direct quotations without attribution to allow for an open discussion of the topic and to ensure the privacy of those involved. Where applicable, the size of an investor s real estate portfolio is provided. The views expressed in the report do not represent the opinion of Shelter Rock. Finally, this report would not have been possible without the generous support of the institutional investors and consultants interviewed. Shelter Rock sincerely thanks all the LPs and consultants involved in this report for sharing their time and expertise and their sincere desire to share insights for the benefit of all industry participants. COPYRIGHT: LP Perspectives: Real Estate Obsolescence, Portfolio Risks and Opportunities Copyright by Shelter Rock Capital Advisors LLC (2018), 45 Rockefeller Plaza, New York, New York Shelter Rock Capital Advisors is a registered broker-dealer and member of FINRA/SIPC. Author: Zoe Hughes LP Perspective: Real Estate Obsolescence, Portfolio Risks and Opportunities Q

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12 Contact Us: Shelter Rock Capital Advisors LLC 45 Rockefeller Plaza, New York, New York