Home Alts News A New Look at an Institutional Commercial Real Estate Allocation Strategy

A New Look at an Institutional Commercial Real Estate Allocation Strategy

Many pension funds, endowments and other institutional investors have experienced large losses in their commercial real estate (CRE) portfolios during the last few years and much of this was from nonexistent or poor asset allocation and portfolio diversification strategies. In addition to an allocation program for CRE, institutional funds need a detailed investment policy statement and manual. While a thorough investment policy/manual program is necessary and may enhance potential returns, the primary driver of CRE returns is to apply a formal and detailed asset allocation and diversification program.

Institutional Asset Allocation

Many pension funds and other institutional investors allocate CRE investment funds in to the three property risk classifications of core, value-added and opportunistic and then in to various markets and property types. Allocation into these risk classifications is necessary; however, it should be the second step in a more comprehensive allocation investment strategy. A comprehensive investment allocation strategy should begin with the four quadrant approach to real estate investment. The four quadrant approach is a CRE investment strategy that was first written about by Joseph Ori, the author of this article, in the summer 1995 issue of Real Estate Review magazine and further developed by Heitman Properties, Ltd, Property, Portfolio and Research and others in the 1990’s. The program first allocates the total investable capital to CRE between the public and private real estate markets and then into debt and equity investments within each of these markets. The public CRE equity market is comprised of REITs and real estate operating entities, primarily hotel companies and the private equity market includes all other non-public CRE investment programs including non-traded REITs, private equity funds, closed end funds, commingled funds and special account funds. The public CRE debt market is comprised of CMBS loans and the private debt market includes all private financing from banks, savings and loans, Wall Street, mortgage bankers and private lenders that issue first mortgage loans, subordinate loans, mezzanine loans, bridge loans and participating loans. A graphic representation of the four quadrant investment program is shown in Table I below:

Table I-Four Quadrant Investment Program

Once funds are allocated to the four quadrants, the next step is to allocate the private equity portion to the three risk classifications of core, value-added and opportunistic, the public equity portion to REITs and the debt portions to public and private categories as desired. Some may question including public REITs in the CRE as opposed to the stock equity investment sector of an institutional fund, as REITs have an 80% correlation with the Russell 200, small cap stock index (according the National Associate of Real Estate Investment Trusts, December 2014, Reit Watch Report). However, many practitioners believe that public REITs should be included in the CRE sector because they provide liquidity, transparency, long term returns similar to private real estate equity and when included in the four quadrant program, increase return and lower risk. According to a Summer 2011 article written by E. Todd Briddell, President and CIO and Alan Supple, Portfolio Manager of Urdang Securities Management, including public REITs and private real estate equity in mixed asset portfolios produces an efficient frontier line as shown in Table II below.

Table II-Efficient Sets with REITs and Private Real Estate

Both are Better Than One (1994-2010)

Average Return Per Quarter
Average Return Per Quarter

As show in the graph, including public REITs and private real estate in a mixed asset portfolio moves the efficient frontier line up and to the left which signifies more return at less risk. The final step in the four quadrant investment program is to diversify by geography, industry and property type. A summary of the steps to a comprehensive four quadrant investment approach for a $100 million CRE allocation with proposed percentage allocations are as follows:

• Determine investment allocation, leverage and return requirements from the fund’s investment policy statement and manual

• Allocate funds to achieve investment levels of 50% in private equity, 25% in private debt and 25% in public equity

• Allocate private equity to core (33%), value-added (33%) and opportunistic (34%)

• Diversify private equity investments by property type, geography and industry

• Diversify debt investments by property and loan type

• Select real estate managers for fund allocation

See below for a flow chart of the $100 million CRE four quadrant investment program:

Institutional investors should consider using the four quadrant investment allocation strategy as the cornerstone of a CRE investment program. Use of the allocation strategy will lower portfolio risk and increase returns.