Independent quantitative real estate researcher Mitchell Bollinger says that the internal rate of return (IRR) metric is overly ingrained in the property industry and prompts investors to take too much risk in underperforming non-core funds.

“Investors are paying gigantic fees for very negative alpha,” Bollinger told the Investment Magazine Market Narratives podcast.

In a paper published last year for the Journal of Portfolio Management, Bollinger and the University of Chicago’s Joseph Pagliari looked at the returns of private real estate investments, including ‘core’ funds, and non-core ‘valued-added’ and ‘opportunistic’ funds.

Core funds are generally levered in 20 per cent and open-ended; value-added funds invest in properties with less-table cash flows, are closed-end, and levered in mid-50 per cent range; while opportunistic assets have the least amount of cash-flow certainty, such as development projects, and are levered in 65 per cent range and closed-end.

The paper found that over the 18-year period from 2000 to 2017, inclusive, non-core funds generated an alpha of around -3.0 per cent. At the same time, investors in value-added funds were taking on 75 per cent more risk than core funds, and opportunistic funds 110 per cent more risk.

“Investors were very much not getting a decent return for the unit of risk they were taking.”

Alpha even worse

The paper also found that over the 18-month period it wasn’t possible to time the market. “The takeaway is that investors would have been much better off either using external leverage to lever up core funds,” or using core-plus funds that are like core funds but use higher levels of leverage.

Additionally, Bollinger says that value-added and opportunistic funds don’t have quarterly liquidity, so the price discovery mechanism isn’t as good as core funds, which have appraisals. Idiosyncratic risk – as opposed to systemic risk – is also much higher for non-core funds.

“If risk is under measured it would be under measured for value-added and opportunistic funds for investors who may not have sufficient diversity across [many] of these funds to really effectively diversify away that idiosyncratic risk,” he says. “If anything, the alphas would be even worse because of that idiosyncratic risk.”

To listen to the full interview with Mitch Bollinger on the Market Narratives podcast click above or find the series on Apple Podcasts, Google Podcasts or Spotify.

IRR drives demand

Despite the poor returns and risk, demand for non-core funds has been strong.

Bollinger says that fiduciaries need to consider both return and risk and the most prominent return metric used in the private real estate industry, certainly in closed-end funds, is IRR.

“But IRR has no concept of either a market to benchmark against nor a concept of risk,” he says. “Yet this is what people seem to think value is. Investors agree to pay over an IRR hurdle rate all the time and… that implies they think it’s value. It’s not.”

Bollinger notes that there is no shortage of academic studies saying, “this [IRR] is not what you should be looking for”.

Ingrained in the industry

Bollinger outlined the example of investing in fund levered at 75 per cent. Over the previous eight years, this would have performed well, with asset prices having much higher returns than the cost of debt.

But if you run into something like the great financial crisis, a core fund would drawdown down 35 per cent, but the levered fund could be down 80 per cent. “That could wipe out eight years of otherwise good performance.”

“If you were paying above an IRR hurdle rate for those eight years, and paid big fees to the manager, then in the last year you lose 80 to 90 per cent of it, you’re not doing that great,” he says. “You might feel good for eight years but that’s why fiduciaries are supposed to be looking at both risk and return.”

The root of the problem

But IRR “is just so ingrained in the industry.”

Bollinger says many real estate people come from development or real estate asset management background, but when they start making financial decisions “they may not have the financial tools and knowledge available to do their job effectively”.

That leads to investors paying big fees for negative alpha. His paper found that over the 18-year period, investors in core funds paid fees of 1 per cent of invested assets, versus 3 per cent in value-add funds and 4 per cent in opportunistic funds.

“You have non-core funds [and] you’re paying three to four times as much for fees, whereas you would have been dramatically better off had you just invested in a core fund, paying that lower fee, and applied more leverage to it.”

Bollinger notes that if non-core fund investors paid the lower fees of core funds, there wouldn’t be a material difference in alpha. “The root of the problem is fees,” he says.

A new estimate of alpha

To solve the problem of investors overpaying for beta, which Bollinger says is an issue in private equity generally, investors need a methodology to work out how to make a reasonable estimate of what alpha is. That would allow investors to change compensation to pay for performance, but not for over an IRR hurdle.

He says he is currently working on a draft paper that outlines a best-practice methodology to estimate alpha. “What it does is it also incorporates a market-based benchmark and adjusts for risk… This is what fiduciaries should be doing all day and they’re not.”

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