INSIGHTS

On May 17, 2012

The Case For Core Real Estate

By Casey Frazier, CFA, Chief Investment Officer - Versus Capital Advisors, LLC

Commercial real estate is an asset class that includes many different strategies and approaches. Investors segment real estate investments into a few categories. This segmentation is done by several key factors including income profile, leverage, operational risk and potential returns. The most important segmentation is core versus non-core, or properties with stable income versus properties that have unstable or no income. In addition to stable income streams, core real estate typically has low leverage, limited operational risk, and moderate and more predictable returns.  Non-core real estate is often characterized by higher leverage, more operational risk, and higher potential returns.

Core Real Estate:

Many investors break the core segment category into two groups: core and core-plus.  Core real estate generally targets high quality real estate assets, minimal levels of leverage (0-30%), a stable tenant base, limited leasing risk, conservative yield-focused return targets, and a modest expectation for capital appreciation. The core-plus style includes the same assets as core, but seeks to use higher leverage of typically 30%- 50% in an effort to boost returns beyond those achieved through a core strategy. In addition, core-plus investing can also target smaller assets and smaller markets provided they are well located, well leased, without near-term rollover exposure, stable, and a traditional property type. Like core, core-plus emphasizes a substantial share of expected total return to be derived from income or yield.

Core properties are the real estate equivalent of core fixed income because of their income characteristics and their ability to preserve capital. Well leased core assets in major markets have historically held their value in down real estate cycles. Because of its stable return and capital preservation characteristics, a significant portion of institutional real estate allocations, especially in pension funds, are in core portfolios [1]. The income tends to exceed actual core fixed income over time, which is appropriate since these portfolios do have a moderate amount of real estate operating or equity risk.  (see figure 1)

*Past Performance doesn’t guarantee future performance.

 

Source: Barclays Capital and National Council of Real Estate Investment Fiduciaries (“NCREIF”).

Figure 1 compares the income return of  NCREIF Fund Index-Open End Diversified Core Equity (“NFI-ODCE”),  an index of investment returns of open-end commingled funds pursuing a core investment strategy (the proxy for private core real estate funds), and the Barclays Aggregate Bond Index (the proxy for the broad domestic fixed income markets).

Non-Core Real Estate

Non-core real estate covers everything that does not fit in the core segment. Typically non-core assets have limited to no income or unpredictable income. Non-core includes a wide range of situations including: properties with a meaningful vacancy; properties in need of renovation; properties in need of repositioning; properties in need of redevelopment; or, new development properties. Non-core properties are often broken into two styles: value-added or opportunistic. The value-added style typically focuses on more aggressive active asset management and often employs more leverage. It generally involves buying a property, improving it in some way, and selling it at an opportunistic time for a gain. The opportunistic approach is normally viewed as the high end of the risk/return spectrum and includes investing in emerging markets, development projects, distressed assets and nonperforming loans. Non-core properties are the real estate equivalent of equity investing because of their appreciation focus and the higher operating risk. As a result, there can be a large return disparity between the best performing non-core real estate and the worst performing non-core real estate. 

Current Individual Investor Objectives 

In our discussions with investment advisors and individual investors, we noted they were looking for the following attributes in their search for investments in the current market environment:

Income- With interest rates at historic lows, investors are looking for investments that generate a competitive yield.

Lower Volatility- Since the global financial crisis, the risk appetite for investors has changed and they are looking for diversification in their portfolios outside of the traditional stock and bond markets.

Inflation Protection- Investors are concerned about future inflation as budget deficits continue to expand across the globe along with significant expansions in monetary policy.

Liquidity- Significant volatility in the equity market has investors concerned with being able to access their capital.

Time horizon- As the baby boom generation begins to retire, most of the investing public has a mid- to long-term time horizon with a change in focus from capital accumulation toward de-accumulation or the spending phase.

 

Given this backdrop, we believe that deciding where to allocate within the real estate sector is critical.  Based on the needs and objectives of the “average” investor described above, we believe that the optimal real estate allocation for individual investors should be a significant allocation to core real estate.  

 [1] IREI Tax-Exempt Real Estate 2009 Survey, Casey Quirk Analysis

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com

The information contained herein is written by Versus Capital Advisors, LLC and is believed to be reliable. The information is not warranted as to completeness and accuracy and is subject to change without notice. The foregoing has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security.

Advisors Asset Management, Inc. (AAM) and Versus Capital Advisors, LLC are not affiliated and the views expressed in this commentary are not necessarily that of AAM. Versus Capital Advisors, LLC is the investment adviser of the Versus Capital Multi-Manager Real Estate Income Fund. AAM is the sub-distributor for the Fund.