Practical analysis for investment professionals
12 December 2019

Private Real Estate Fund Categories: A Risk/Return Assessment

Private real estate funds generally fall into one of three categories. Based on increasing levels of risk and, accordingly, expected returns, a fund’s strategy is designated core, value-added, or opportunistic.

But is this categorization system accurate? Are the realized net-of-fees returns by strategy commensurate with the associated risks?

Subscribe Button

To answer that, we examined the risk-adjusted performance of all three categories of private real estate funds and found that investors are paying approximately $7.5 billion in fees annually that are economically unwarranted.

The chart below illustrates the nature of the data sets we employed.

Private Market Real Estate Returns by Category: A Comparison of Data Sources

Chart of Private Market Real Estate Returns by Category: A Comparison of Data Sources

The risk/return performance of each strategy, before and after fees, from 2000 to 2017, is summarized in the following chart. To improve tractability, we created composite indices from the underlying data sets for the value-added and opportunistic strategies.

Private Market Real Estate Index Performance, 2000–2017

Chart of  Private Market Real Estate Index Performance, 2000–2017

To understand the volatility of value-added and opportunistic returns, it’s important to realize that the standard deviation of net returns understates the potential capital risk to the investor. Why? Because the promoted (or carried) interest paid to the fund manager reduces the upside of the investor’s net return but does not affect the downside risk.

Therefore, the volatility of the gross return better captures the risk of capital loss.

Estimating Alpha from a Levered Risk/Reward Continuum

To assess the risk-adjusted, net-of-fees returns of non-core, or high-risk/high-return funds, we simply applied additional leverage to the returns of core funds.

This levering up creates a risk/return continuum by which we can assess risk-adjusted, net-of-fee performance of non-core funds through the volatility of gross returns. (We estimate the cost of debt to increase with the leverage ratio and, consequently, the risk/return is curvilinear.)

This risk/return continuum is depicted in the following graphic based on the volatility-adjusted performance of non-core funds and the law of one price. To replicate the volatility of the value-added returns, we increased the leverage ratio on core funds to approximately 55%. For the volatility of the opportunistic returns, we boosted the leverage ratio to around 65%.

Estimated Alphas of Non-Core Funds, 2000–2017

Chart depicting Estimated Alphas of Non-Core Funds, 2000–2017

Given the identical volatilities, such as those between core with additional leverage and the value-added and opportunistic indices, the “alphas” for indices of value-added and opportunistic fund performance are graphically represented by the vertical distance between the core-with-leverage continuum and the average realized returns of the value-added and opportunistic indices.

The value-added funds produced, on average, a negative alpha of 326 basis points (bps) per year, as demonstrated in the preceding chart, while the opportunistic funds generated a negative alpha of 285 bps.

Estimating the leverage ratio of core funds needed to replicate the net-of-fee returns of value-added and opportunistic funds provides another perspective on the underperformance of non-core funds. As the subsequent graphic shows, investors could have realized identical returns to the composite of value-added funds by leveraging their core funds to less than 35%. (Actual core funds were leveraged less than 25%.)

Estimated Leverage Ratios Required to Replicate Net Returns of Non-Core Strategies, 2000–2017

Chart depicting Estimated Leverage Ratios Required to Replicate Net Returns of Non-Core Strategies, 2000–2017

Had they followed this approach, investors would have experienced less volatility — approximately 650 bps less per year — than had they invested in value-added funds. Moreover, investors could have realized identical returns to the composite of opportunistic funds by leveraging their core funds to less than 50%. That would have meant less volatility — about 700 bps less — than had they invested in opportunistic funds.

Analyzing the Subperiod Performance

The global financial crisis (GFC) devastated the real estate market and non-core properties and funds, in particular. To determine whether the once-in-a-generation event disproportionately tainted these study-long estimates of alpha (–3.26% for value-added and –2.85% for opportunistic funds), we have to analyze performance over different holding periods

The following two charts apply the same methodology to estimate alphas, by strategy, over any subperiod greater than five years. The first displays subperiod alphas for the value-added composite.

Value-Added Funds: Estimated Alpha (with Confidence Level) for Various Holding Periods

Chart of Value-Added Funds: Estimated Alpha (with Confidence Level) for Various Holding Periods

What did we find? Every subperiod produced a negative alpha — including the holding periods that concluded before the GFC, when non-core funds would have presumably outperformed core funds.

The last graphic shows the identical analysis for the composite of opportunistic funds. The results are very similar to value-added funds, with substantial underperformance before and after the GFC.

Opportunistic Funds: Estimated Alpha (with Confidence Level) for Various Holding Periods

Chart showing Opportunistic Funds: Estimated Alpha (with Confidence Level) for Various Holding Periods

Clearly, the GFC did not disproportionately taint our study-long estimates of alpha, with measures of –3.26% for value-added and –2.85% for opportunistic funds. Instead, these negative alphas displayed considerable persistence across many time periods.

Why Such Underperformance?

Significant and persistent underperformance by non-core strategies begs the question, Why do so many institutional investors allocate their real estate capital to them?

Our study takes a novel approach to non-core fund performance. Perhaps institutional investors are unaware of these outcomes. Or maybe they’ve dismissed this underperformance as merely a run of bad luck.

Alternatively, institutional investors could (irrationally) create mental accounts for core, value-added, and opportunistic “buckets” — effectively walling them off from one another. Or maybe leverage has something to do with it: Unable or unwilling to apply it, certain investors instead seek higher returns through higher-risk assets.

Another possibility: Maybe public sector pension funds have increased their allocations to non-core investments in response to deteriorating funding ratios.

Financial Analysts Journal Latest Issue Graphic

What Can Be Done?

Whatever the reasons, for investors, this underperformance has a steep price.

All told, the size of the value-added and opportunistic markets and their underperformance adds up to approximately $7.5 billion per year in unnecessary fees. By investing in core funds with more leverage, investors could have avoided them.

So what can be done to minimize the risk of such underperformance going forward?

Investors might consider some combination of the following:

  • Allocate more capital to core funds that apply more leverage.
  • Demand more and better data on the performance of non-core funds.
  • Advocate that non-core investment managers reduce their fees.
  • Replace the investor’s fixed preference with an index that has risk/return characteristics similar to the non-core fund.
  • Place a fixed ceiling on the fund manager’s incentive fee.

If you liked this post, don’t forget to subscribe to the Enterprising Investor.

All posts are the opinion of the author(s). As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/zhangxiaomin

Professional Learning for CFA Institute Members

CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker.

About the Author(s)
Mitchell Bollinger, CFA

Mitchell Bollinger, CFA, most recently was the head of research at Courtland Partners, a real asset consulting firm located in Cleveland, Ohio, with $65B in assets under advisement. While he was at Courtland, Bollinger’s client was Vanguard for whom he wrote and presented a report which detailed the relationship between traded real estate investment trusts (REITs) and non-traded real estate in terms of how to consider private real estate in a diversified portfolio of traded assets, how to measure the risk and risk adjusted returns of private real estate in comparison to traded REITs, and suggested a private real estate fund structure that likely would complement a portfolio of traded assets for Vanguard clients. Prior to Courtland, Bollinger founded a firm that managed a fund which invested in traded REITs based upon his proprietary research. He was previously an asset manager for KBS Realty Advisors in Atlanta for five years where he oversaw a portfolio that averaged 15 properties and had an aggregate value of over $1B for five years. After graduate school, Bollinger worked in the CMBS industry in New York City where his clients included Merrill Lynch and Bear Stearns. Bollinger holds a BS in industrial engineering from Virginia Tech and an MBA from Vanderbilt University. He is both a CFA charterholder and a CAIA charterholder.

Joseph L. Pagliari, Jr., PhD, CPA, CFA

Joseph L. Pagliari Jr., PhD, CPA, CFA, focuses his research and teaching efforts — based on over 35 years of industry experience — on issues broadly surrounding real estate investment, attempting to answer important questions from a rigorous theoretical and empirical perspective. These issues include: the risk-adjusted performance of core and non-core funds, principal/agent issues in incentive fees, a comparison of REITs and private real estate, real estate’s pricing and return-generating process, real estate’s role in a mixed-asset portfolio, the strategic uses of leverage, etc. And, accordingly, he has authored (or co-authored) numerous papers on a variety of these topics, including: “An Overview of Fee Structures in Real Estate Funds and Their Implications for Investors” published (as a special research project) by the Pension Real Estate Association, “The Pricing of Non-Core Real Estate Ventures” published in The Journal of Portfolio Management; “Public versus Private Real Estate Equities: A More Refined, Long-term Comparison” published in Real Estate Economics; “Public v. Private Real Estate Equities: A Risk/Return Comparison” published in the Journal of Portfolio Management; and “Twenty Years of the NCREIF Property Index” published in Real Estate Economics. He has also co- authored several chapters in the Handbook of Real Estate Portfolio Management, of which, he is also the editor. He has presented these papers and thoughts on other topics at a variety of industry events (including ARES, AREUEA, NCREIF, NAREIM, PREA and ULI) as well as the Federal Reserve Bank of Atlanta and testimony before a subcommittee of the House of Representatives. His views on these and other topics have also been published in the popular press, including Barron’s and The Wall Street Journal. Pagliari is board member of the Real Estate Research Institute (RERI) and a former board member of the Real Estate Information Standards (REIS). He is also a member of numerous academic and professional associations including the American Real Estate Society (ARES), the American Real Estate and Urban Economics Association (AREUEA), the Homer Hoyt Institute (where he is a Hoyt Fellow), the National Association of Real Estate Trusts (NAREIT), the National Council of Real Estate Investment Fiduciaries (NCREIF), the Pension Real Estate Association (PREA) and the Urban Land Institute (ULI). Pagliari was also the 2015 winner of PREA’s James A Graaskamp Award (which recognizes those who have, through significant research, contributed practical insights to the common body of knowledge). Pagliari earned a bachelor’s degree in finance from the University of Illinois-Urbana in 1979. He earned an MBA from DePaul University-Chicago in 1982 and a PhD in finance from the University of Illinois-Urbana in 2002. His interests include sports of most every kind — some of which he still plays.

12 thoughts on “Private Real Estate Fund Categories: A Risk/Return Assessment”

  1. Dr. Laurence Brody says:

    an impressive study

  2. Qasim Qayyum says:

    Dear Team,

    Very nice article. Just wanted to know what do you mean “Core & non-core fund”. It was better if you would have explained it in the Article.

    1. Mitchell Allen Bollinger says:

      Core – Open ended funds that invest in properties with stabilized cash flow and have historically employed leverage in the 20% range.
      Value added – Closed end funds that invest in properties that have uncertainty in their cash flow (low occupancy and requires some capex) and have historically used leverage in the 50% range.
      Opportunistic – Closed end funds that invest in properties that have the most uncertainty in their cash flows (development, empty buildings) that have historically used leverage in the 60% range.

      These are the hard and fast rules. Joe’s initial paper provides some more insight.

  3. Martin Schwarzburg says:

    Hi Mike/Joe –

    great article. Especially the need for better/more granular data on fund performance is key for institutional investors to arrive at meaningful decisions.

    Couple of thoughts:
    a) How would you balance a cap on incentive fees with the ‘carrot’ needed to ensure performance and alignment of interest between GP’s & LP’s?

    b) Would you advocate bifurcated GP performance reporting in order to distinguish between leverage related returns and those generated by managing real estate risk?

    c) Do you see more in-housing of non-core strategies as part of the solution to enhance institutional investor’s risk/return structure?


    1. mitchell bollinger says:

      What seems to have a poor understanding in the practitioner world is that a promote fee does not align the interests of GPs and LPs. A promote looks like a call option where the GP gets all of the upside and none of the downside but the LP gets all of the downside. For anyone who doubts this, try drawing out the payoff diagram.

      I don’t lose sleep over not including an incentive fee for two reasons. The first is that if one creates an incentive fee based upon alpha, then a GP could create positive alpha yet have negative nominal returns. This does not sit well with pensioners but is financially the right way to do it. The second is that the incentive for the GP to perform well is to have more capital allocated to them in the future. In short, investment management is not a one time game.

      The difference in equity risk can be bifurcated into two sources. The difference in risk due to the difference in asset level risk and the difference in financial leverage. Having GPs report asset level returns would remove fully half of this source of the difference in equity risk and this is an easy way to make a risk adjustment. Measuring the difference in asset level risk is hard. But reporting at the asset level and comparing performance at the asset level would be a gigantic step in the right direction.

      What we found was that the largest difference in alphas was due to the difference in fees. So fees matter… a lot. Anything investors can do to control fees is a good thing. That being said, investors need to hire competent managers and they need to be paid. But extremely competent firms such as JPM have lowered the lowest tier fee they charge on their core and core plus funds to a fixed fee in the 50 bp range. If you can get JPM for 50 bp I am not sure why you would agree to pay anything much more than that if you are a large institution and are working at scale where you can get these fee breaks.

  4. Marijan says:

    very useful article.. thanks for sharing this with all

  5. Lee says:

    Great info, I think the issue is you are looking at averages. Institutions likely believe they can identify top quartile performance, at least that is their claim. According to a study I read, the difference in top and bottom quartile performance is significant in Value Add ~2,900 bps (22% vs. -7%).

    1. mitchell bollinger says:

      Stay tuned for our follow up study where we consider the alpha generated by individual funds, quantify how the cross section of these alphas look, and investigate whether there is any persistence in alpha between managers’ subsequent funds.

      We intend to disentangle luck from skill.

  6. Mitchell Bollinger, yet another fantastic value based article based on research, and I think all the tips are the result of learning through experience, that’s why they are so much valuable for the readers.

  7. Charles Zhang says:

    Dear Martin,
    Very good article. But I think why core fund doesn’t increase their leverage is that the gross rental yield (not total return) is hard to cover interest expenses and meet the banker interest coverage ratio requirement after deducting asset level expenses since core funds are using long-term operating loan. On the other hand, the value add or opportunistic fund are using construction loan or acquisition loan which is to be totally paid back though asset sale or refinance. In conclusion, the market is segmented as core, value add and opportunistic through realistic market practice. Simply gearing up core funds may only be theoretical. Hope to discuss further with you.

  8. Allen Wilson says:

    Thank you for sharing this.

  9. Kevin Higgins says:

    Looking forward to your follow up study.

Leave a Reply

Your email address will not be published. Required fields are marked *

By continuing to use the site, you agree to the use of cookies. more information

The cookie settings on this website are set to "allow cookies" to give you the best browsing experience possible. If you continue to use this website without changing your cookie settings or you click "Accept" below then you are consenting to this.