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

Possible Constraints on Advisor Creativity

The fact of ownership control confers on real estate the possibility of entering into many activities to affect performance. In such an environment, the possibilities are bounded only by human creativity and energy. It would be a shame if rigid conformance to style box attributes resulted in thwarting the evolution of the creative process.

For example, real estate has not yet really explored the world of futures, options and derivatives. There is the possible use of synthetic debt to partition the income stream ownership from valueadded ownership (Graff, 2002). Contract innovations include the use of forward contracts to reduce development period risks. New ownership structures have been offered to investors, such as the private real estate investment trust (REIT), where independent boards, answerable to the investors, oversee the advisor and/or sub-advisors. The 1990s witnessed the development of the modernera UP-REIT as an alternative exit strategy for large private portfolios. The use of small amounts of development to enhance core returns without noticeably adding to risk has proceeded in recent years, with consultants continuing to label such funds as "core." Does possible capital markets arbitrage (public/private, for example, as discussed in Anderson and Liang 2001) increase or reduce risk, as it seeks to enhance returns?

Further, what is to be done with the advisor who varies style over the changing phases of the real estate cycle: buying core or near-core opportunistically at market bottoms (as with the RTC in the early 1990s), engaging in speculative development as the economy gains momentum, and holding cash and lower-risk core properties as the cycle tops out? In stock market management this might be labeled as "style rotation," and can be a risky endeavor. However, with real estate's analyzable trends (e.g., above or below replacement cost) and longer cycle lengths, such changing activities can be seen as intelligent management.

Does international investing add risk (currency, legal, political, remote operational) and thereby relegate this activity to "opportunistic" styles only? Or does it reduce risk by virtue of lower-correlation diversification for a U.S.-only portfolio?

Tellingly, in the survey, one consultant said, "If you really could put a finger on the appropriate benchmark, you would take away creativity." Managing to a benchmark in public securities often leads to a tightly bunched set of "peer" performers all doing pretty much the same thing. Fortunately, or not, for real estate the possibility of tightly defining a benchmark seems remote.

Performance Feedback Loop Can Result in Style Box Drift

In any manager search process, the consultant usually culls the potential list of advisors to those who fit the style box and are otherwise perceived as reliable prospects, unlikely to embarrass the consultant. The final choice is often left to the investor committee. The firm that wins the business often has the best performance track record, especially if it has been consistent in recent years. The losing firms then seek to mimic the activities of the winning firm in order to get back in the game. Witness the drift in one of the risk attributes in real estate-the use of leverage. Ten years ago, "core" styles would include only un-levered properties-the classic NCREIF definition. Looking at Exhibit 6A, today's competitive pressures and lower interest rates have allowed the boundary to drift as high as a 50% loan-to-value leverage, and still be considered core by some players! Perhaps, in time, such a "drift" will be considered a rational "shift." In other ways, too, core managers have sought to engage in as much higher return value-added activity as they can without causing consultants to assign them to the next higher risk style box.