Investment Division Education Program

Investment Division Education Program

October 19, 2017: Real Estate

Steve Sexauer, CIO SDCERA Continuing Education Program

October 19, 2017, Real Estate

Trustee Education Curriculum

1. Measuring Performance 2. All About Risk 3. Real Estate A. Market Terms and Structures

B. Real Estate Fundamentals and Return Drivers C. Real Estate in a Pension Portfolio D. Discussion and Questions

2 Steve Sexauer, CIO

SDCERA Continuing Education Program October 19, 2017, Real Estate

Part A. Market Terms and Structures

Mike Comstock, Aon Hewitt

3 Mike Comstock, Aon Hewitt

SDCERA Continuing Education Program October 19, 2017, Part A, Real Estate

Real Estate Risk Spectrum Defined

Core – Most conservative real estate investment strategy focused on owning high-quality, stabilized properties in the most liquid and economically diverse/vibrant markets. Low use of leverage, and significant focus on current income yield. Often referred to as the “Beta” of the asset class. REITs – Access to real estate through securities traded in the public markets. Similar qualities as Core but slightly higher leverage. The liquidity benefit that comes from being traded daily has a trade-off in the form of higher volatility than private Core and thus is elevated on the risk spectrum. Value-Added – Focused on a balance of increasing property-level income and enhancing underlying asset appreciation to create value. Moderate use of leverage expected. Strategies generally focus on leasing, repositioning, and redevelopment. Opportunistic – Most tactical style of real estate investment, usually focused on enhancing/creating significant value appreciation. Significant use of leverage is common; limited focus on current income. Opportunistic investing is most successful when there is an imbalance in the real estate or capital markets. Strategies include: development, capital stack restructuring, change of property use, distressed asset/ownership/market conditions, public-to-private transactions, and emerging sectors.



Property Types



• The term “Real Estate” commonly refers to investments in commercial property • Institutional quality real estate refers to the subset of higher quality properties in medium to large markets, and largely focuses on the following property types:

• “Niche” properties can also be found in institutional portfolios: - Hotels, senior housing, student housing, self storage, medical office and land - Timber and farmland

Real Estate by Style



Capital Stack Defined



• Equity represents the highest risk in the capital stack • Debt can be further broken into multiple pieces

Source: Albourne

Real Estate Risk-Return Falls Between Stocks and Bonds

Core Real Estate’s risk-return profile normally falls between fixed income and equities

Equities experience a larger growth rate but are also more volatile, while Fixed Income provides less volatility but has limited growth potential



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Risk-adjusted returns – Trailing 25 Years Ending 6/30/2017

Source Data: Core Real Estate - NCREIF NFI-ODCE, Global Equities - MSCI ACWI, Broad Fixed Income - Barclays US Aggregate

Real Estate Indices/Benchmarks



For programs investing through funds on the private side, we recommend using the NFI-ODCE:

• The index takes into account leverage, cash drag, and other portfolio management items; • Captures quarterly mark-to-market valuations on debt and equity; • Available on net-of-fees basis; and • Meets the formal definition of a benchmark

REIT Benchmarking: • REITs have grown tremendously in size over the last 25 years • Efficient exposure to the asset class - market cap and total assets greater than the tracked in the

private Core market

NCREIF – The National Council of Real Estate Fiduciaries NFI-ODCE – The NCREIF Fund Index-Open Ended Diversified Core Equity US REITs – United States Real Estate Investment Trusts

Part B. Real Estate Fundamentals and Return Drivers

Heather Christopher, Albourne

10 Heather Christopher, Albourne

SDCERA Continuing Education Program October 19, 2017, Part B, Real Estate

Performance

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• The 2007 recession negatively impacted current 10-year trailing returns of the recovery from the 2009 lows, but also boosted the 3-year and 5-year trailing returns

Heather Christopher, Albourne SDCERA Continuing Education Program

October 19, 2017, Part B, Real Estate

Fundamentals: What Drives Returns, Part 1



Source: NCREIF

Source: NCREIF

Capital: What Drives Returns, Part 2



Note: Dry powder is an industry term meaning undeployed capital commitments available to buy investments; the charts estimate the aggregated capital seeking deals at each point over the above timeframe

Real Estate Valuations



Source: NCREIF

Source: NCREIF

Core Transaction Volume



Source: NCREIF

• No one wants to lock in a loss at the bottom of a cycle • Following the 2007 recession, a global pursuit of yield resulted in cash flows pursuing real

estate that would normally be allocated to fixed income

Part C. Real Estate in a Pension Portfolio

David Rose, Aon Hewitt

16 David Rose, Aon Hewitt

SDCERA Continuing Education Program October 19, 2017, Part C, Real Estate

Sizing up the Market



Four Quadrants of Real Estate U.S. Institutional Real Estate Universe

Private Equity is the most common method of accessing real estate and refers to the direct ownership of real estate through pooled funds or separate accounts

Private Debt comprises a more indirect method of investing and is accomplished through the issuance or purchase of mortgages that are collateralized by real estate

Public Equity investing involves buying publicly traded shares of real estate companies such as Real Estate Investment Trusts (REITs) and Real Estate Operating Companies (REOCs)

Public Debt investing involves buying publicly traded shares of real estate companies such as Mortgage Real Estate Investment Trusts (REITs), mortgage-backed securities (MBS) or Commercial Mortgage-Backed Securities (CMBS)

$5.1 trillion $1.0 trillion

$6.0 trillion $1.5 trillion

The Role of Real Estate in a Pension Portfolio



Investment Objectives

Real Estate can play a variety of roles within a multi-asset class investment portfolio including: − Diversification − Yield − Potential to Hedge Inflation − Enhanced Returns

Sector Drivers

Real Estate is a cyclical asset class impacted by: Economic Growth (Jobs) Construction (New

Supply) Capital Markets (Interest

Rates)

Program Benefits & Challenges

Diversification benefits to total plan

Opportunity for both beta and alpha exposures

Characteristics include: low correlations, strong cash flow, capital preservation and attractive risk-adjusted returns

Challenges include cyclical asset class, limited liquidity, extended time to realization, control, and transparency

Diversification



Private core real estate has had a low correlation to the traditional asset classes historically due to: Income yields that provide stability but aren’t fixed and respond to inflationary pressures and

economic growth Valuation process that is independent from public market sentiment

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Five Year Rolling Correlations (Q4 1984 - Q4 2016)

Core RE/Global Equity Core RE/US FI

Source Data: Core Real Estate - NCREIF NFI-ODCE, Global Equities - MSCI ACWI, Broad Fixed Income - Barclays US Aggregate

Downside Protection Over the last 35 years, core real estate has only had two drawdown events where the benchmark has

fallen over 10%; this compares to six such events for global equities Real estate drawdown events:

Early 1990s – Oversupply from loose construction lending in the 80s 2008-2009 – All return-seeking asset classes experienced re-pricing



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Drawdown Analysis - Global Equities vs Core Real Estate

Global Equities Core RE

Source Data: Core Real Estate - NCREIF NFI-ODCE, Global Equities - MSCI ACWI

Forward Looking Expectation for Portfolio Returns and Volatility



Incorporating Core Real Estate within a multi-asset portfolio helps investors achieve a similar total return with less volatility

The below graph illustrates this concept using two efficient frontiers: The blue curve shows a portfolio with only fixed income and equity allocations The red curve depicts a portfolio that includes a 15% allocation to core real estate within the

return-seeking assets (equity) allocation

Example: If targeting a 60/40 RS/RR Portfolio, adding Core RE reduces the expected total portfolio volatility by approximately 100 bps for the same expected total return

Fundamentals Remain Relatively Healthy



All property types moving in positive direction on occupancies and rental rates, Hotel and Apartment sectors showing some signs of slowing

Muted new supply has been a major tailwind to date; pace of new completion differs by sector; Apartment sector actually forecast for drop in new deliveries after 2017

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Apartment Industrial Office Retail Hotel

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Retail Office Industrial ApartmentSource: CBRE-EA 3/31/17 Source: CBRE-EA, 3/31/17

Pricing, Yields & Spreads



Sources: RCA, 6/30/2017 Sources: NCREIF, US Treasury 6/30/17

While the trend for pricing continues to move upward, the last 18 months has witnessed some capitulation in all property types at various points

Risk premiums for stabilized real estate showing signs of slimming with uptick in long duration risk free rates that began in late 2016, expectations are for thinner premiums in 2017 and this cycle of cap rate compression coming to an end

Investor Flows into Core



Investors have heavily poured capital into US Core real estate since the Global Financial Crisis, however 2016 was a year of moderation with redemptions nearly matching contributions and 2017 is flat through mid-year

Select funds have formed exit queues as investor sentiment has cooled a bit on the asset class

Source: NCREIF NFI-ODCE, AHIC: 6/30/2017

Return History & Near Term Expectations



The NFI-ODCE returned 8.3% over the trailing one-year; moderating toward the long run average Momentum is slowly waning as the cycle matures from recovery to expansion, yield compression is

largely complete, total returns will be more dependent on increasing income (cash flow growth) at this point

Consensus expectations for 2017 total unlevered property level return is 6.4% (Source: PREA Q3 2017 Survey)

Source: NCREIF NFI-ODCE, AHIC: 6/30/2017, *Long Term return is 30 year annualized ending 6/30/2017

Glossary • Alpha: The amount by which an investment outperforms its benchmark on a risk-adjusted basis; alpha can

be positive or negative • Beta: The sensitivity of an investment to the market • Brownfield (real estate): Land previously used for industrial or commercial use that may have let to

contamination by low concentrations of hazardous waste or pollution, and has the potential to be reused once it is cleaned up

• Cap Rate: The ratio between the net operating income produced by an asset and its capital cost (the original price paid to buy the asset) or alternatively its current market value

• Co-Investment: The syndication of capital for an investment, usually alongside a commingled fund • Core Real Estate: Core is the most conservative institutional real estate investing style • Core-Plus Real Estate: Core-Plus is a style whereby investments have a slightly higher level risk and

expected return relative to Core, primarily through the use of increased leverage • Correlation: The extent to which the return patterns of two assets are similar • Current Value Cap Rate: Cap rate based on the estimated value of a property (aka market value) • Development: The construction of buildings from breaking the ground through building completion; this

may also include entitlement of the land and the pursuit of permits prior to construction • Derivative: A financial instrument which derives its value from the price of underlying assets, such as

stocks, bonds, oil prices, or pork bellies • Distressed Debt: A strategy involving investment in equity or debt in investments that are unable to service

existing debt; often such investments have defaulted and are facing foreclosure



Glossary (cont’d) • Dry Powder: Industry term meaning undeployed capital commitments available to buy investments • Fund of Funds: A fund which invests in a portfolio of underlying funds, which then invest capital directly;

despite the extra layer of fees, they provide a route to investing in primary funds that would otherwise be closed to them

• Greenfield (real estate): Undeveloped land in a city or rural area either used for agriculture, landscape design, or left to naturally evolve and may be considered for urban development; such land does not have hazardous waste or pollution contamination

• Highest and Best Use (“HBU”): The possible or probable use of a given property that produces the highest value; this may differ from the current use of the property

• Internal Rate of Return (“IRR”): The measurement of a portfolio’s actual performance between two dates, where greater weighting is given to those time periods when more money is invested; also known as dollar weighted return

• Investment Grade Bonds: High quality debt securities that are unlikely to default on their obligations • J-Curve: The curve realized by plotting the returns generated by a fund against time (from inception to

termination) • Land Speculation: Purchasing land believing that the price will increase typically through HBU; such that

strategies are high risk vacant land is likely to have expenses, such as taxes and insurance, that exceed rental income (like farming); such momentum plays are usually dependent on the development of surrounding parcels making it scarce and in demand

• Loan-to-Value Ratio (“LTV”): A ratio of a loan relative to the value of the property collateral



Glossary (cont’d) • Leverage: Taking investment positions with borrowed money or derivative positions such that the total

investment exposures (long short plus) exceed the fund’s total assets • Liquidity: The extent to which a security can be purchased or sold quickly at a fair price • Lockup: The amount of time before an investment manager can be terminated and the assets withdrawn • Market Value: The price at which an asset would trade between a willing buyer and willing seller • Mezzanine: An investment strategy involving subordinated debt (the level of financing senior to equity and

below senior debt) • Multiple: The sum of the total proceeds (distributions and appreciation upon sale) returned to an investor

over a hold period divided by the investor’s initial investment • NCREIF: The National Council of Real Estate Fiduciaries is a not-for-profit organization established in

1982 to collect, validate, and disseminate real estate performance and benchmarking data • NFI-ODCE: The NCREIF Fund Index – Open-ended Diversified Core Equity is a quarterly time weighted

return measure of performance of a US open-ended Core real estate funds with properties acquired in the private market for investment; NFI-ODCE data begins in 4Q1978

• Non-Core: Styles that have risk greater than that of the Core real estate style • NOI: Net Operating Income • NPI: The NCREIF Property Index is a quarterly time weighted return measure of the performance of US

Core institutional real estate properties held by both funds and separate accounts acquired in the private market for investment; NPI data begins in 4Q1978



Glossary (cont’d)



• Opportunistic Real Estate: Style of real estate in which the investor is willing to take entrepreneurial risk to achieve outsized return; includes strategies such as ground-up development, adaptive re-use or change of use, distressed debt, and land speculation

• Preferred Equity: A direct equity investment with a fixed, preferential return that is paid prior to distributions to the “common” equity interest in the owner

• Redevelopment: New construction on an existing structure to typically change its use while leaving a portion of the original structure in tact

• Secondaries: Investment made in existing private equity assets usually through the sale of commingled fund interest or portfolios of direct investments the purchase of these investments from existing institutional investors

• Senior Debt: Debt that takes priority over other unsecured or otherwise more “junior” debt owed by the borrower

• Time-Weighted Return (“TWR”): Measurement of investment performance by eliminating all the effects of capital additions and withdrawals; essentially it is the return on the first dollar invested

• Transaction Cap Rate: Cap rate resulting from a sale of a property • Transitional Assets: Assets whose utilization moves from one use to another • Value-Added Real Estate: Style of real estate where investors seek to take moderate risk in improving

properties that tend to have high vacancy or some physical obsolescence • Vintage Year: The first year in which an investment, usually in a fund, is made • Volatility: The standard deviation or variability of security returns; this is the most common measure of

risk in investment portfolios

Documents

Investment Division Education Program