TO THE MEMBERS OF THE COMMITTEE ON INVESTMENTS/ INVESTMENT ADVISORY COMMITTEE: DISCUSSION ITEM

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1 Office of the Treasurer 604 TO THE MEMBERS OF THE COMMITTEE ON INVESTMENTS/ INVESTMENT ADVISORY COMMITTEE: For Meeting of November 9, 2004 DISCUSSION ITEM REAL ESTATE INVESTMENT PROGRAM UPDATE - slide presentation This document presents an Investment Plan for the five percent real estate allocation for the University of California Retirement Plan (UCRP) and the General Endowment Pool (GEP). Summary The primary purpose of this document is to present a plan to invest the five percent allocation to real estate as presented to the Committee on Investment and the Investment Advisory Committee in April 2003 and approved by The Regents in May This plan is a predominantly private market program that differs from the dual public-private plan described at the April 2003 meeting. The principal reason for this change is that a mostly private market strategy more effectively captures the investment benefits of this asset class for the overall portfolio and increased cash flow potential for the asset class. Previous Actions: Future Actions: At its meeting on April 22, 2003, the Committee on Investments voted to recommend to The Regents a new five percent allocation of the University s retirement and endowment plans to real estate. The Treasurer s Office has recently hired Jon Willis, formerly of Russell Real Estate Advisors, to manage the real estate investment program. It has also retained The Townsend Group, a leading institutional real estate consulting company, to be The Regents Consultant for this asset class. The Treasurer s Office will report on the progress and performance of the real estate investment program in conjunction with its regular quarterly financial reporting to The Regents. The proposed changes to the Real Estate Investment Guidelines are incorporated in Item 603 in Attachment 3. Report Outline: I. U.S. Real Estate Market II. Real Estate Investment Strategy III. Investment Plan Implementation IV. Investment Plan Guidelines Attachment 1: Current U.S. Real Estate Market Attachment 2: The Investment Selection Process Attachment 3: Investment Plan Guidelines (Blackline)

2 Office of the Treasurer of The Regents Real Estate Strategy Executive Summary This document presents a revised investment plan for the five percent allocation to real estate approved by The Regents in May The most significant revision is that the original plan contemplated a dual public-private investment strategy while the new plan centers on a predominantly private strategy. The primary reason for this change is that public real estate investments (REITs) are closely correlated with equity investments. Since one of the University s principal reasons for investing in real estate was to gain greater portfolio diversification, i.e. reduced correlation among the various asset classes, private real estate investments are a more suitable vehicle for this allocation. The dollar amount of the five percent real estate allocation will be approximately $2.2 billion, based on the size of the UCRP and GEP capital pools on June 30, It is expected to take three to four years to fully commit this allocation and five to six years to invest the commitments. The new investment plan includes four strategies, defined as core, enhanced, and high-return strategies in private sector, and a fourth strategy centering on the public real estate market. The program will invest exclusively in commingled funds in its private market strategies and through third-party managers in its public market strategy. The program will not have any direct investments. Core strategies will be implemented through investments in eight to ten open-end funds and will comprise a targeted 50 percent of the program s total investment. The universe of both existing and new open-end fund managers will be actively reviewed to ensure that the University s program is invested with the best-performing and best-managed funds. In addition, the Treasurer s real estate staff will actively manage the capital allocations among mixed-sector and single-sector funds to exploit expected changes in sector performance. Non-core strategies, which are identified as enhanced and high-return strategies, will be implemented through investments in closed-end funds. These investments will comprise a targeted 40 percent of the program s total investments. Closed-end funds are typically six to eight years in fixed duration and generally target specific property improvement strategies that are expected to produce higher returns. The Treasurer s staff will select fund managers who have demonstrated their ability to implement the proposed strategies. These strategies may include non-u.s. investments. Finally, the plan s public market strategy will be implemented by two to four managers that seek investment opportunities in under-valued companies. These investments will comprise a targeted ten percent of the program s total investment. REIT investments may also be made to secure access to property sectors that are more efficiently acquired through the public market. The current U.S. real estate investment environment is unusual in that high prices have been sustained in the face of deteriorating operating fundamentals in most real estate markets for the past several years. Although these fundamentals are now improving, there is a risk that current pricing levels will not be sustained. Strategies appropriate to this environment include (1) Careful property type selection to emphasize those sectors that will enjoy the greatest benefit from improving fundamentals; (2) Strategies that entail adding value to under-performing properties, i.e. enhanced investment strategies; and (3) Consideration of non-u.s. investment options.

3 I. U.S. Real Estate Market The current U.S. real estate investment climate is unusual in comparison to past investment cycles. The fundamentals of the institutional property market that is, occupancy levels, rental rates, and other indicators of the general health of the sector steadily weakened between late 2000 and Despite this weakening, real estate prices generally held steady or even improved because of the continuing demand for this asset class. This demand has come largely from institutional investors who are shifting their capital out of fixed-income and common equities in response to weakening conditions in those two asset classes, and from non-institutional investors who have been attracted to real estate by historically low interest rates. Both types of investors are largely driven by the attractive cash flow attributes of this asset class. For this reason, the current pricing of real estate is a concern. Although property markets are now improving with the nation s strengthening economy, there may be downward pressure on property pricing as interest rates increase in response to this same economic improvement. The challenge in the current environment is to select those strategies that exploit the prospects of improving market conditions while mitigating the adverse affects of rising interest rates. Three investment strategies that may be used in this environment are: Careful property type selection; investing in those property sectors expected to enjoy the most immediate benefit from improving market conditions while minimizing exposure to those property types that may be most sensitive to interest rate increases. Invest more heavily in enhanced strategies; these strategies specifically seek under-performing properties that will enjoy a proportionately greater advantage from improving market conditions. Selectively invest outside the U.S.; such considerations should focus primarily on Western Europe, Mexico and Japan. (See Attachment 1 for a more detailed discussion of the current U.S. real estate market) - 1 -

4 II. Real Estate Investment Strategy The real estate investment strategy presented to the Regents on April 22, 2003 (Item 602B) proposed a dual public/private investment program, with 40% of the capital to have been invested in real estate investment trusts (REITs) and the balance in private real estate, primarily in limited partnerships and similar pooled investment vehicles. These investments were to have been made entirely through thirdparty managers in the case of the public market investments (REITs) and through commingled funds for the private real estate investments. Original Strategic Allocations Strategy Allocation Range Public Market (REITs) 40% 30%-50% Private Market (Funds) 60% 50%-70% Total 100% The current investment strategy is a primarily private market program with a target allocation of 90% to private commingled funds and a 10% to the public markets. This recommendation is based on the following considerations: This strategy will more effectively accomplish one of the primary objectives of the real estate allocation; namely, to provide broader diversification to the overall portfolio. A lower allocation to REITs will result in a lower level of volatility in the real estate portfolio. The graph below illustrates the pro forma impact of real estate on the overall investment portfolio if it were implemented in accordance with the program discussed on the following pages. The yellow diamond up and to the left of the magenta square indicates that real estate has the potential to modestly increase the return of the overall portfolio while at the same time moderately reducing its risk. Total Risk and Return with 5% Real Estate 8.00% 7.50% 7.00% 6.50% 6.00% 5.50% 5.00% 4.50% 4.00% 5.00% 10.00% 15.00% 20.00% US Equity Bonds 65/35 Eq/Bond 65/35 w /RE - 2 -

5 Strategic Allocations Within the private market part of the investment program there will be a targeted 50% allocation to core strategies and 25% and 15% allocations each targeted to enhanced and high-return strategies, respectively; these strategies are defined below. The core, enhanced and high-return strategies will be accessed through commingled open and close-end funds sponsored by outside investment managers. External managers will also be hired to implement the REIT strategy. The allocations to the various strategies and their recommended ranges are summarized as shown below. In terms of their risk/return characteristics, REITs are typically categorized between core and enhanced strategies as shown in this schedule. Core Strategies Proposed Strategic Allocations Strategy Program Access Allocation Range Core Private Open-end funds 50% 30%-60% REITs Public REIT managers 10% 5%-20% Enhanced Private Closed-end funds 25% 20%-35% High-Return Private Closed-end funds 15% 0%-25% Total 100% Core real estate is typically defined as institutional-grade property that is operationally stabilized. One of the most efficient ways to access core real estate is to invest in open-end funds. These commingled investment portfolios are diversified by property sector over a broad geographic area. The funds are semi-liquid in that they typically accept new investor commitments or satisfy existing investor redemption requests on a quarterly basis. The largest funds invest in all four major property sectors: office buildings, rental apartments, shopping centers and industrial facilities; some funds also include hotels. The goal of an open-end fund manager is to secure higher returns through careful asset and market selection along with thoughtful sector allocation. Open-end funds and core portfolios in general are only modestly leveraged, usually limited to about 25%. Publicly Traded Real Estate Securities Real estate investment trusts, or REITs, are publicly-traded companies whose primary assets are a portfolio of institutional-grade properties. The properties are generally operationally stabilized, so in this sense REITs are like a core real estate strategy. But REITs are also typically 40%-50% leveraged, they often include a modest development component, and the portfolio is actively managed; so in this context REITs are like an enhanced real estate strategy. The primary use of REIT investments is that they provide opportunities to add value to a portfolio through buying under-priced companies that are expected to grow in value. Annual REIT cash flows (dividends) have historically been in the 5%-7% range. Enhanced Strategies Enhanced investment strategies typically entail acquiring moderately under-performing properties, adding improvements and selling, generally in a four to six-year period. Under-performing properties are those that are under-leased, under-maintained or under-managed; or some combination of these deficiencies. Since these properties are inherently in a state of transition it is difficult to value them on a normal basis. Accordingly, enhanced strategies are implemented through closed-end funds, wherein the investors have committed their capital to the investment manager for a predetermined period of generally 6-8 years, similar to private equity, during which time the manager executes this strategy for a broad portfolio of properties. Enhanced strategies generally use about 50% leverage

6 High-Return Strategies High-return real estate strategies entail a wide range of sub-strategies including investments in nonperforming loan portfolios, structured financing, distressed assets, real estate operating companies, raw land and new development. Some high-return strategies involve investing outside the U.S. High-return funds often assume leverage up to 75%. (The University s real estate program is limited to a blended 50% leverage across the entire portfolio.) Risk/Return Factors The forecast risk and return factors for each of these strategies are shown in the schedule below. These factors have been estimated by The Townsend Group based on the historic performance of funds that have implemented these strategies since 1985, as well as Townsend s own expectations for the performance and volatility of funds implementing these strategies over the next five years. Risk and Return Forecast by Strategy Core Strategy Public REITs Enhanced Strategy High-Return Strategy Expected Return 7.25% 8.25% 9.25% 12.75% Standard Deviation 7.00% 13.50% 12.00% 20.00% Note that standard deviation, an indicator of risk, has a different character here than it does in the fixedincome and common equities markets due to limited data and the smoothing of reported returns that results from appraisal pricing. Also note that the increased risk of enhanced and high-return strategies is partly due to operational factors and partly due to the use of financial leverage. As a result, the efficient frontier analysis shown below should be thought of as indicative rather than exact. Risk/Return and the Efficient Frontier The illustration below shows the Efficient Frontier derived from the risk and return factors shown in the schedule above and reflects a prospective return of about 8.68% with a standard deviation of 9.03% for a portfolio with the targeted allocations to the various strategies. The most aggressive real estate portfolio within the allowed ranges would provide a 9.38% return and a standard deviation of 10.91%, while the most conservative portfolio would provide a 7.85% return and a standard deviation of 7.10%. Expected Return High Return RE Low Risk Core RE Bonds Target RE High Risk Enhanced RE w ith RE 65/35 REITS Equity Standard Deviation (Risk) - 4 -

7 III. Investment Plan Implementation It is expected that the 5% real estate allocation, which would today amount to approximately $2.2 billion based on the June 30, 2004 size of the UCRP and GEP plans, will be committed over the next 3-4 years. Specific strategy implementation would occur as follows. Core Strategies The targeted allocation to core strategies is 50% of the program s invested capital, with a range of 30% to 60% depending on market conditions and investment opportunities. This provides the program with a solid and reliable base that supports two of the fundamental purposes of the real estate allocation: (1) performance that does not correlate with the other asset classes and (2) a strong cash flow return. The property-level cash flow recorded in the NCREIF Property Index (NPI), the primary indicator of core strategy performance, has been about 8% per annum since the inception of the Index in After dilution for capital expenses, the net cash flow has typically been 6.0%-6.5%. Core investments will be made through open-end funds. There are currently 18 open-end funds in the Townsend Open-End Fund Universe, a universe regularly monitored by the program s Consultant. The funds range in size from $61 million to $6.5 billion; the aggregate size of this universe is about $32.3 billion. There are a number of mixed-sector open-end funds that have performed well on a consistent basis. These include Clarion Lion Fund, RREEF America II, PRISA, PRISA II and J.P. Morgan s Strategic Property Fund. Investments may also be made in sector-specific funds that provide investors with the ability to make sector selections with tactical over-weights to those property types that appear to hold the potential for better performance. SSR Realty Advisors (apartments) and AMB Property Company (industrial properties) are two reputable managers that expect to introduce sector funds to the market in The core investment part of the real estate program in particular recognizes the importance of sector allocations by controlling more closely the guidelines applicable to property type selection in this portfolio. This matter is discussed in greater detail in Section IV, Investment Strategy Guidelines. When the plans 5% allocation to real estate is fully deployed the investment in open-end funds will probably be in the $1.25 billion range. Management currently expects to commit up to $400 million to as many as six open-end funds over the next twelve months. However, there are entry queues to most of these funds that will probably take 6-9 months to clear before these commitments can be invested. A second round of open-end fund investing will be made in the second year of the program s development. Real Estate Investment Trusts REIT investments will be made with active managers who invest their allocations in accordance with the strategies they have been hired to employ. These strategies will generally be to invest in under-valued companies or in sectors that cannot be readily accessed in the private market. In view of the recent run-up in REIT prices, initial allocations to this strategy will be made carefully. Selection of REIT managers will follow the same process used in selecting the private real estate managers. At full deployment REIT investments would likely represent $200-$250 million of the plan s invested capital and would probably be managed by three or four external REIT managers. Management may deploy up to $50 million in REIT investments in the first year of the program s development and an additional amount in the second year

8 Enhanced Strategies Higher-risk real estate strategies, meaning enhanced and high-return strategies, are typically implemented through closed-end funds. Most of the program s investments in closed-end funds will be in the $50 million range, although some commitments may be as high as $75 million. This level of investment allows for selecting managers with different sub-strategies and does not overexpose the plan to a particular advisor. The investment strategy provides that the program will target 25% of its capital to enhanced strategies. There are several qualified advisors that regularly bring new closed-end enhanced funds to the market. Among the managers that staff will consider for these types of investments are Fidelity Management, AEW Capital Management, LaSalle Investment Management, TA Associates, and DRA Advisors. At full deployment enhanced strategies would likely constitute just over $600 million of the program s capital. This amount would probably be invested among eight to ten managers. Staff anticipates investing up to $400 million in enhanced strategies in the first and second years of the program s development. High-Return Strategies High-return investments provide a vehicle for generating potentially out-sized returns if they are made under carefully considered circumstances. At full deployment high-return strategies would also likely constitute up to $400 million of the program s capital and would likely be invested among eight to ten high-return closed-end funds. Staff anticipates investing up to $250 million in high-return strategies in the first and second years of the fund s development. Particular care will be taken in the selection of these investments in view of the greater risk inherent to these propositions. Among U.S.-focused high-return managers, Blackacre, Lubert-Adler, Rockpoint, Westbrook, Praedium, Rockwood Capital, Walton Street Capital, and Starwood Capital are all regarded as seasoned managers with reputable track records. Non-U.S. real estate investment Non-U.S. investment strategies are typically implemented through closed-end enhanced or high-return funds and have tended to focus on distressed financial institutions in parts of Asia and changes associated with the development of the European Union in Europe. Credible managers implementing these strategies include Lone Star, Morgan Stanley, LaSalle Investment Management, Lehman Brothers, CSFB, Colony Capital and Aetos Capital. Global real estate strategies are expected to have an increasing role in institutional investment programs. Many institutions today invest internationally on a tactical basis, using these strategies to broaden their universe of investment opportunities and to capitalize on global market inefficiencies and special situations. A number of global investment vehicles also include a U.S. allocation. As globalization continues to take hold in the broader economy, cross-border real estate investing is a logical extension of most institutional investment programs. The investment management business is also becoming more global as evidenced by recent merger activity among international real estate companies. With these changes is an accompanying standardization of investment practices and increasing market and business transparency in the major non-u.s. investment regions. Investment Selection Process Investment selection will be an iterative and collaborative process between the Treasurer s Office staff and The Regents Consultant. A diagram outlining this process is shown in Attachment

9 IV. Investment Plan Guidelines The purpose of these investment guidelines is to define investment objectives, philosophy, and specific guidelines for making investments, and the benchmarks to measure performance. Allocations and ranges for the four principal strategies are shown below. Strategic Allocations Strategy Allocation Range Core Real Estate 50% 30%-60% REITs 10% 5%-20% Enhanced Strategies 25% 10%-35% High-Return Strategies 15% 0%-25% Total 100% Core real estate, Enhanced strategies, and High-return strategies are combined below under the heading Private Real Estate. REITs are referred to in the section Public Real Estate Investment Guidelines Private Real Estate 1. The benchmark for evaluating the performance of private real estate investments is the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index (NPI). The program is expected to meet or exceed this benchmark after deducting all costs and expenses. 2. Investments will be in limited liability investment vehicles such as limited partnerships, limited liability corporations, private REITs and other pooled investment funds. 3. Investments will be primarily equity-oriented, but may also include debt instruments secured by real estate with equity-like returns. 4. Specific property types in the portfolio will be within the following ranges: Property Diversification Guidelines Property Type Range Office 20%-50% Apartments 15%-35% Industrial 15%-35% Retail 10%-30% Other up to 10% 5. Investments in the U.S. will be diversified by geographic location with no one metropolitan area exceeding 10% of the portfolio. 6. Investments outside the U.S. may not represent more than 10% of the private real estate portfolio and must be diversified by property type and geographic location. 7. An investment in any one fund will not exceed 20% of the total capital being raised for that offering

10 8. No more than 10% of the program s assets will be invested with a single core manager and no more than 5% of the program s assets will be invested with a single non-core (Enhanced or Highreturn) manager. 9. The outstanding investment(s) with any given sponsor, or related sponsors, may not exceed 15% of that sponsor, or related sponsors, total real estate equity under management. 10. In order to properly align the interest of the investor and the sponsor, the sponsor of a closed-end fund investment will be required to make a co-investment of at least 1%. 11. Leverage at the portfolio level will not exceed 50% of the market value of the assets. All leverage shall be non-recourse to the Retirement Fund. Investment Guidelines Public Real Estate 1. The benchmark for evaluating investment performance for REIT managers is the Dow Jones- Wilshire REIT Index. Managers are expected to meet or exceed this benchmark after deducting all costs and expenses. 2. At least 90% of the portfolio assets must be invested in securities included in the benchmark index. No more than 10% of the portfolio may be invested in non-us companies. 3. No property type may exceed two times that property type s weight in the benchmark index. 4. The weighting of any individual security cannot exceed more than two times its weight in the benchmark index. 5. The Retirement Fund s investments in any given security may not exceed 4.5% of the equity capitalization of that security at the end of any quarter. 6. No investment with any single manager can represent more than 25% of the public real estate portfolio. 7. No investment with any single manager may exceed 25% of that manager s total assets under management. Note: Compliance with some of these guidelines will not be required until a sufficient number of investments have been made. The Office of the Treasurer will keep the Investment Committee apprised quarterly as to the status of its compliance with these guidelines in its Investment Performance Summary Report

11 Attachment 1 Current U.S. Real Estate Market The illustration below shows the investment returns for U.S. institutional real estate over the past 25 years as indicated by the NCREIF Property Index (NPI). The NPI is the primary benchmark for institutional property investment performance. It is currently composed of about 4,000 institutionalgrade properties with an aggregate market value of approximately $140 billion. 25% 20% 15% 10% 5% 0% -5% -10% -15% The dark portion of the bars shows the annual current return for the Index in its respective years and the lighter portion shows the gain or loss in value each year. In 1991, for example, the Index recorded a current return of 6.8% and value depreciation of -17.8%, for a net total return of -5.6%. By contrast, in 1998 the Index recorded a current return of 8.8% and value appreciation of 7.0%, for a total return of 16.2%. (Components do not add to total due to time-weighted calculation.) Over the past three years the Index has remained fairly constant with a total return of between 6.7% and 9.0%. One of the most important factors highlighted by this graph is that income from real estate investments has been nearly constant over this time period at about 8.0% annually, irrespective of the year-to-year changes in property value. After dilution for capital expenses, the net cash flow has typically been 6.0%-6.5%. The current real estate investment climate Appreciation Return (NPI) Income Return (NPI) Average Income Return (NPI) The current real estate investment climate is unusual. The fundamentals of the institutional property markets steadily weakened from late-2000 to Fundamentals refer to property vacancy levels, rental rates and other criteria that measure the general health of this asset class. Vacancy levels in nearly every property type in nearly every market throughout the U.S. are now higher than their longterm averages, and rent levels are either stable or still moderately declining. In the face of these weakening fundamentals, however, real estate prices have generally held steady or even improved. This is because the broader capital markets, including institutional capital pools such as the University s retirement and endowment plans, have recognized the portfolio benefits of real estate and gained a greater appreciation for the role of this asset class in their investment programs. Like the University, they have redirected capital previously allocated to other asset classes to real estate. This has increased the demand for this asset class and hence its cost. As long as real estate continues to deliver these relative benefits, this re-allocation process is likely to continue. 1

12 Attachment 1 Forecast market conditions A demand-driven recovery for real estate is beginning to emerge. U.S. GDP growth has been positive for 10 quarters and has been particularly strong over the past year. Job growth in the early summer of 2004 finally appeared to be gaining momentum. Real estate usually lags general economic growth and operating fundamentals in this asset class have just recently begun to show signs of improvement. Positive absorption (net occupancy gain) has begun in select markets and is now expected in all major property types over the next several years. This should eventually lead to upward pressure on rents. Capitalization rate compression and expansion The current pricing of real estate, however, remains a concern. A fundamental measure of commercial property pricing is change in capitalization rates. A property s capitalization rate is composed of its value, or price, divided by its net income. Changes over time in capitalization rates for the major property sectors are shown in the graph below. Capitalization rates have been declining over the past two years because of historically low interest rates and increased capital flows into this asset class. When more investors are competing for a fixed amount of property, they are typically willing to pay a higher price for the same income, and property capitalization rates come down, or compress. This is good for owners and sellers of real estate because it adds and extra measure of return to their investment performance. But if interest rates return to their longer-term averages, as they are expected to do over the next several years, capitalization rates will likely shift upward as well. Rising capitalization rates, or capitalization rate expansion, diminish the return to owners of real estate. Cap Rates by Property Type As of 6/30/ % 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% Source: NCREIF, Economy.com Jun-85 Dec-85 Jun-86 Dec-86 Jun-87 Dec-87 Jun-88 Dec-88 Jun-89 Dec-89 Jun-90 Dec-90 Jun-91 Dec-91 Jun-92 Dec-92 Jun-93 Dec-93 Jun-94 Dec-94 Jun-95 Dec-95 Jun-96 Dec-96 Jun-97 Dec-97 Jun-98 Dec-98 Jun-99 Dec-99 Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Apartment Industrial Office Retail 10 Year Treasury 2

13 Attachment 1 Thus, the real estate investment environment over the next several years will likely be characterized by both improving fundamentals, which increases the value of real estate, and rising capitalization rates, which reduces the value of these assets. The investment manager s challenge in this environment is select those strategies or sub-strategies that exploit the prospects of rising fundamentals and at the same time mitigate the adverse affects of capitalization rate expansion. Careful property type selection One way to achieve these advantages is through careful property type selection, emphasizing those property sectors expected to enjoy the most immediate benefit from improving fundamentals while minimizing exposure to those property types that may experience the most capitalization rate expansion. The schedule below summarizes the changes in capitalization rates among the major property sectors over the past 18 years. It shows that the greatest capitalization rate compression in that time period occurred in the apartment sector, suggesting that extra care should be given to investment decisions in this particular area since it would be most vulnerable to capitalization rate expansion. With regard to improving fundamentals, the industrial sector is broadly expected to recover faster than the office sector. The retail sector has actually enjoyed strong fundamentals for the past several years and is probably more vulnerable to capitalization rate expansion without commensurate improvements in fundamentals. Changes is U.S. Property Sector Capitalization Rates Avg. Cap Rates Office Industrial Apartments Retail % 9.05% 8.39% 9.12% Q % 7.61% 5.39% 7.53% Variance 1.08% 1.44% 3.00% 1.59% Invest in enhanced strategies A second way to secure higher returns in the current environment is to invest more heavily in enhanced strategies. These strategies intentionally seek under-performing properties with the specific intent of fixing these deficiencies and selling the assets profitably. There are now an abundance of moderately broken properties that should benefit from improving fundamentals and better management. The key to successfully exploiting these opportunities will be to select managers with the appropriate skills and resources to effectively execute enhanced strategies. Consider non-u.s. investments A final way to secure higher returns in the current environment is to consider investments outside the U.S. Such considerations should focus primarily on Western Europe, Mexico and Japan. While Western Europe has many features of a mature state with limited growth potential, there are nonetheless enhanced strategies available in this region that have been brought about by the continuing evolution of the European Union. Mexico, by contrast, is in many respects an emerging state with more high-return opportunities for profitable investment. Asia, with Japan as the dominant economic force producing just under half the region s GDP, is a mix of both industrialized economies and emerging states, with both enhanced and high-return investment opportunities. Most of these opportunities are the result of the Japanese real estate bubble in the 1980s that is still adversely affecting the financial institutions of that country. 3

14 Attachment 2 The Investment Selection Process The Treasurer s Office is responsible for the implementation and management of the real estate investment program and will adhere to policies and guidelines approved by The Regents Investment Committee. Within the Treasurer s Office, the real estate program will be devised, implemented and managed by the Real Assets Investment Officer, under the direction of the Managing Director of Alternative Investments and the Treasurer. This effort will be completed in collaboration with the Regents real estate Consultant as shown in the diagram below. Screen to meet minimum criteria Reject Initial consideration by Treasurer s Office Reject Consultant Initial Review Treasurer s Office Further Review Reject Accept Reject/Track Prioritize for due diligence Consultant Due Diligence Treasurer s Office Due Diligence Reject Review by Real Assets Committee Reject/Track Approval by Treasurer s Office Reject Manager contract negotiated and investment made Reject Report to Investment Committee and Investment Advisory Committee 1

15 Attachment 3 Investment Plan Guidelines The Real Estate Investment Guidelines governing the investment strategy approved by the Regents on April 22, 2003 are shown below. There are a number of recommended changes to these Guidelines. Investment Guidelines Private The proposed benchmark for measuring performance is the NCREIF Property Index (NPI). This Index was developed by the National Council of Real Estate Investment Fiduciaries. The general investment guidelines for the private equity component of the program are as follows: 1. Investments shall be in limited liability investment vehicles such as limited partnerships, limited liability corporations, private REITs and other pooled investment funds. 2. Investments shall be primarily equity-oriented, but may also include debt instruments secured by real estate with equity-like returns. 3. Specific property types in the portfolio shall be within the following ranges: Office: 0-50% Industrial, retail and multi-residential: 0-35% each Other (hotel, single family residential, healthcare, and specialty such as golf courses, agricultural: 0-10%. Recommended change: As noted in Section III of this report, the Treasurer s staff will optimize the program s portfolio performance through tactical over/under-weightings among the primary property types. This will be accomplished by controlling the capital commitments to the various funds to exploit expected changes in sector performance. The recommended investment ranges are shown below. Property Diversification Guidelines Property Type Range Office 20%-50% Apartments 15%-35% Industrial 15%-35% Retail 10%-30% Other up to 10% 4. Investments in the U.S. shall be diversified by geographic location with no one region (West, Midwest, East or South) exceeding 50% of the private real estate portfolio [with no one metropolitan area exceeding 10% of the portfolio.] Recommended change: The four regions designated in the original plan do not appropriately identify geographic diversification. A more meaningful geographic diversification measure is by metropolitan area. It is recommended that the blended portfolio have a limit of 10% in any U.S. metropolitan area. 1

16 Attachment 3 5. Investments outside the U.S. may not represent more than 20% 10% of the private real estate portfolio and must be diversified by property type and geographic location. Recommended Change: In the original investment plan, with its 60% allocation to private market investments, this guideline placed a 12% limitation on the program s non-u.s. investments. The revised plan, with its 90% allocation to private market investments, would result in an 18% limitation on the program s non-u.s. investments. It is recommended that this guideline be changed to establish that investments outside the U.S. be limited to no more than 10% of the private market portfolio. 6. Target sub-allocations and ranges are (a) 40% Core strategies within a range of 25-75% and (b) 60% Value and Opportunistic strategies combined within a range of 25-75%. Definitions are shown below. The higher allocation to Value and Opportunistic strategies is based on the premise that Core real estate has return and risk characteristics that are similar to public real estate and thus Core should be under-weighted in the private real estate strategy. Recommended Change: This change was noted earlier in Section II of this report and is illustrated again below. Proposed Strategic Allocations Strategy Allocation Range Core Real Estate 50% 30%-60% REITs 10% 5%-20% Enhanced Strategies 25% 10%-35% High-Return Strategies 15% 0%-25% Total 100% 7. The Regents An investment in any one fund shall not exceed 50% [20%] of the total capital raised for that offering. Recommended Change: The private market strategy will be implemented exclusively through investments in commingled funds. One of the characteristics of pooled funds is that fund risk is mitigated by investing proportionately with other qualified investors. Peer plans typically limit their participation in commingled offerings to 20%-25% of the total capital raised for that fund. It is recommended that this guideline be changed so that the University s investment in a fund can represent no more than 20% of that fund s total investment capital. 8. No more than 25% of the private real estate portfolio may be invested with one sponsor or group of related sponsors. Recommended Change: This guideline is intended to protect the program from undue manager risk ; that is, a concentration of its assets among too few investment managers. It is recommended that no more than 10% of the program s portfolio be invested with a single core manager and that no more than 5% of the program s portfolio be invested with a single non-core manager. [No more than 10% of the program s assets will be invested with a single core manager and no more than 5% of the program s assets will be invested with a single non-core (Enhanced or Highreturn) manager.] 9. The Regents outstanding investment(s) with any given sponsor, or related sponsors, may not exceed 25% [15%] of that sponsor, or related sponsors, total real estate equity under management. 2

17 Attachment 3 Recommended change: This guideline is also intended to protect the program from undue manager risk by ensuring that the prospective transfer of assets from a given manager would not impair the viability of that manager s on-going business. It is recommended that the program s portfolio represent no more than 15% of a manager s assets under management. 10. In order to properly align the interest of the investor and the sponsor, the sponsor of a closed-end fund investment will be required to make a meaningful [at least a 1%] co-investment in the offering. Recommended change: The co-investment requirement for a closed-end fund is more specifically defined as 1% of the offering. 11. Leverage at the portfolio level shall not exceed 50% of the market value of the assets. All leverage shall be non-recourse to The Regents [the Retirement Fund]. Investment Guidelines Public The proposed benchmark for measuring performance is the [Dow Jones-] Wilshire REIT Index. The general investment guidelines for public real estate investments are as follows: 1. At least 90% of the portfolio must be in the benchmark index with no more than 10% of the portfolio being securities of publicly-traded companies incorporated outside the US, but in G-10 countries ex. US (UK, Germany, France, Belgium, the Netherlands, Italy, Sweden, Canada and Japan) [assets must be invested in securities included in the benchmark index]. 2. No property type may exceed two times that property type s weight in the benchmark index. 3. The weighting of any individual security cannot exceed more than three two times its weight in the benchmark index. 4. The Regents [Retirement Fund s] investments in any given security may not exceed 5% 4.5% of the equity capitalization of that security at the end of any quarter. 5. No investment with any single manager can represent more than 25% of the public real estate portfolio. 6. No investment with any single manager may exceed 25% of that manager s total assets under management. Recommended change: The two minor changes noted above reduce the program s public investment exposure to any given security. Note: Compliance with some of these guidelines will not be met until a sufficient number of investments have been made. The Office of the Treasurer will keep the IC/IAC periodically informed as to the status of its compliance with these guidelines and as requested [will keep the Investment Committee apprised quarterly as to the status of its compliance with these guidelines in its Investment Performance Summary Report.] 3