Investment Styles and Style Boxes in Equity Real Estate: Can the Emerging Model Succeed in Classifying Real Estate Alternatives?

Journal of Real Estate Portfolio Management, Jan-Apr 2005 by Kaiser, Ronald W

Executive Summary. The real estate industry is working to develop a system of "style boxes," with the recent NCREIF white paper seeking to define "core," "value-added" and "opportunistic" styles of investing in private market real estate. This sterns from the desire for: (1) a framework to facilitate the investment process; (2) a common language; (3) targeted portfolio strategy and balance; and (4) a simpler search and selection process for advisors. However, where style box use in the public securities industry is based on defining the attributes of a benchmark universe, the institutional real estate investment industry seeks to define boxes based on expected risk / return ranges, and then attempts to define the asset attributes and management activities appropriate to that style. The process varies widely, and likely requires further analysis and systematization before it can be widely useful. Even then, sophisticated consultants will be required as on-going referees.

Style Boxes: Now It's Private Real Estate's Turn

In order to make "apples-to-apples" comparisons, institutional investors in publicly-traded securities have long utilized "style boxes" to define and segment portfolio management activities (see Christopherson and Williams, 1995). In this framework, "small company" portfolios are not expected to perform identically with "large capitalization" ones. "Growth" stocks have perceived and measurable differences from "value" stocks. Investment committees routinely review and rank the performance of their various managers by style groups. In the 1970s, a commitment to "real estate" could mean anything from a diversified, unlevered open-end fund to a partnership involved in raw land speculation for single-family homes, with no ostensible distinction of risks. Real estate was real estate. In the 1980s, whatever small amount was invested in real estate could often be differentiated on the basis of whether or not it was of "institutional quality."

With the disastrous effects of the 2000-02 bear market in publicly-traded equities, institutional investors are making increasingly greater commitments to real estate in a search for stability, higher cash income and the potential for significant total return. Prior to 2001, most consultants1 had only infrequent requests for real estate placement activity. Now, almost all general consultants are gearing up their search activity and ability to deal in private real estate-an asset class that many had ignored during the 1990s. In the recently reported 2003 PREA Plan Sponsor Survey, while actual allocations to real estate have moved up from 4.3% in 2000 to 5.5% in 2003, there is much room to grow. Approximately 69% of respondents reported being under-funded relative to their target allocation. Approximately 56% of the reporting plan sponsors had allocation targets of 8% or more. Obviously, real estate placement activity will continue for some time.

In recent years, the real estate industry has increasingly relied upon the style box approach in response to a number of needs.

A Defining Framework for Facilitating the Investment Process

In order to define an investor's objectives, and to direct an advisor's efforts in acquisitions and property management, there has emerged a fuzzy consensus around the terms "core," "enhanced core or core-plus," "value-added" and "opportunistic" as basic style box definitions. "Core" has comprised the bulk of most investors' investments, and has traditionally involved investments in generally fully leased, multi-tenant properties more than $5 million in size, in major metropolitan areas, owned with little or no mortgage debt. "Value-added" approaches generally involve relatively substantial redevelopment or releasing of a property to increase its potential value at a rate in excess of general market trends. "Opportunistic" originally involved the purchase of distressed properties at rock-bottom prices and their redevelopment, but has evolved to other aggressive forms of investing such as new property development and heavily leveraged property ownership. While value-added and opportunistic approaches have gathered an increasing share of new investment activity, core or core-plus remains the cornerstone and has the largest total share of most investors' portfolios.

Facilitating Communication among the Players

With all this activity to search and select, as well as to monitor existing investments, there needs to be a framework and a common language to facilitate the process. As it is, real estate typically requires a much higher level of effort on the part of investors to understand and analyze versus the public stock and bond asset classes. Focusing discussions via the use of style boxes is one approach that can help. Traditional "core portfolio" discussions can be focused on property selection, portfolio diversification and property operating issues, with little need to understand such things as "development risks" or "financial engineering."

Targeting and Balancing Portfolio Strategy