Investment Strategy On-Demand Webinar Series
Private Real Estate Options for DC Plans Jani Venter, Hewitt EnnisKnupp
Viable Private Market Real Estate Vehicles for DC Plans DC Plans can now gain exposure to Private Real Estate through viable investment vehicles as a result of two major developments: A structural evolution in Daily Valued Real Estate funds that addressed historic pricing and liquidity challenges The shift in DC Plans towards pofessionally managed platforms - specificlly Multi-Asset and Target Date Funds Only 26% of DC Participants have the option to invest in Real Estate; allocations averaging 1% and ultimately exclusively to REITs Historic challenges that have limited DC Plan exposure to Direct Real Estate include: Concerns regarding the validity of daily pricing Illiquidity during market dislocations * Source: PSCA s 56th Annual Survey of Profit Sharing and 401 (k) plans, 2013 Trends & Experience in Defined Contribution Plans. 2
Viable Private Market Real Estate Vehicles for DC Plans Daily Priced Direct Real Estate options are now available to DC Plans Products are largely representative of Beta in Real Estate (i.e. Core strategy) Investors can now access the benefits of Direct Real Estate: Stabilized and attractive income yields Attractive absolute risk-adjusted returns Potential hedge to inflation Pure real estate play No public equity volatility No management/enterprise risk or discount/premium to NAV Lower use of leverage For DC Plans the benefits of Direct Real Estate are as follows: Stability and higher riskadjusted returns than portfolios without Direct Real Estate Diversification and increased downside protection Inflation protection without increased volatility Stability due to strong, predictable cash flow from core operating assets and a high long-term income yield Low correlation with other asset classes and Direct Real Estate's stable return profile provides downside protection Direct Real Estate can be added in scale without increasing overal portfolio volatility 3
Direct Real Estate Benefits: Income Focused Return Strategies A significant portion of Direct Real Estate return comes from cash flow linked to long term bond rates, which contributes to a more stable overall return profile Direct Real Estate Return Components Trailing 1-Year Returns 25 20 15 10 5 0-5 -10-15 -20-25 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Annual Return - % Appreciation Income Yield Total Return Source: NCREIF NPI, Hewitt EnnisKnupp 12/31/2013 4
Direct Real Estate Benefits: Diversification and Increased Downside Protection Vehicle valuations are more closely linked to bricks-and-mortar real estate with less influence from global market capital flow, hot dollar investing and the broader public market sentiment Direct Real Estate has a low correlation with publically traded asset classes which supports the diversification benefits when included in a mixed asset portfolio Direct Real Estate Correlation Time period 03/31/1978-12/31/2013 U.S. REITs Equities Fixed Income Direct Real Estate U.S. REITs 1.00 Equities 0.62 1.00 Fixed Income 0.19 0.13 1.00 Direct Real Estate 0.15 0.09-0.12 1.00 Diversification also provides downside protection; Direct Real Estate is less likely to experience negative returns at the same time as a 60/40 Stock/Bond portfolio Over the past 15 years, a 60/40 Stock/Bond portfolio had negative returns in 20 quarters; Direct Real Estate only had negative returns at the same time in 15% of the quarters Source: Direct Real Estate: NCREIF Open-End Diversified Core Equity (NFI-ODCE); U.S. REITs: FTSE NAREIT U.S. Real Estate Index; Equities: S & P 500 Index; Fixed Income: Barclays Aggregate Index. 5
Direct Real Estate Benefits: Inflation Protection Without Increased Volatility Core Direct Real Estate offers the potential for inflation protection over the long term Direct Real Estate can be added in scale without increasing the volatility of the overall portfolio Change in 60/40 Portfolio Volatility from 7% Allocation to Direct Core Real Estate or REITs 15 Years as of 12/31/2013 Change in Volatility 10.5% 10.0% 9.5% Decrease the portfolio volatility by 60 bps Increase the portfolio volatility by 40 bps 9.0% 8.5% 60/40 Stock/Bond Portfolio Direct Real Estate U.S. REITs Direct Real Estate: NCREIF Fund Index Open-End Diversified Core Equity (NFI-ODCE); U.S. REITs: FTSE NAREIT U.S. Real Estate Index; Equities: S & P 500 Index; Fixed Income: Barclays Aggregate Index. 6
Daily Valued Real Estate Vehicles Structural changes to Direct Real Estate vehicles have focused on the following: Reducing potential liquidity risk Improving clarity & frequency of the valuation process Improvements in market transparency (15 20 years) have supported increased real estate market knowledge Shift in DC Plans towards professionally managed platforms multi-asset funds/target date funds has allowed investors to better manage liquidity risk Increased transparency and shift in the DC market has supported a structural evolution in daily valued Real Estate Funds Broader opportunity set of daily valued Direct Real Estate vehicles available to DC Plans today 7
Daily Valued Real Estate Vehicle Structure Fund-of-Funds limited to professionally managed platforms only Structure: 75% Direct and 25% REITs/Cash REITs/Cash provide for daily liquidity Direct Real Estate offers exposure to underlying direct real estate funds Target Date Fund or Multi-Asset funds in Professionally Managed Platform Fund-of-Fund Structure Direct Real Estate Core Core VA VA Liquid REIT & Cash Funds provide daily liquidity (T + 1) with trading restrictions; liquidity is not guaranteed New capital is allocated to liquid sleeve; distributed to Direct Real Estate end of quarter/month Investors gain immediate exposure to blended return In professionally managed products, cash flow modeling of contributions/distribution help management of allocations/weightings to the underlying funds 8
Daily Valued Real Estate Vehicle Structure Daily value of the Fund-of-Funds are calculated by adding up investments underlying funds Value of the interests in underlying Direct Real Estate Funds Value of investments in REITs and cash Subtracting liabilities, daily investment management fees and other expenses Daily value calculation in Direct Real Estate address both income and appreciation components: Income Appreciation Income is forecasted over the quarter/month and adjusted for major lease events or material market changes if required Independent third parties value all assets on a quarterly basis; appraisals are staggered throughout the quarter and recognized on a daily basis Market has evolved to the point where daily values are typically robust and daily pricing provides a fair representation of the underlying real estate value 9
Conclusion DC Plans can now gain exposure to Direct Real Estate through viable investment options Structural redesign, increased trading restrictions and expansions to include a liquidity sleeve have created products that are better able to manage DC plan liquidity needs Daily valued vehicles allow investors to incorporate the Beta of Real Estate and there is proven evidence that adding Core real estate is beneficial to the risk-return profile of a mixed asset portfolio Despite all the improvements, Daily Valued Real Estate funds do not guarantee liquidity and investors must be comfortable with this risk to include these vehicles in a DC Plan We expect the market evolution to continue, but are comfortable with the current generation of funds and their ability to manage the valuation and liquidity requirements of DC plans 10
Contact List Jani Venter Senior Consultant Investment Consulting jani.venter@aonhewitt.com 11
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