The Core Portfolio Manager Dilemma--Take The Money And Run?
It used to be when open-end real estate fund managers had queues to deal with, their clients wanted to take money back, because of poor performance. Today most open end funds have queues—totaling billions of dollars—waiting to get into these sought-after funds, which invest in core real estate concentrated in the top markets. The lumpiness of real estate and the relatively lengthy transaction process would be an advantage to advisors in the old days. They could string out sales, wait for markets to rebound, continue to earn fees, and hope their clients would change their minds when performance turned more positive. In many instances, institutional clients would back off and stay in the funds.
Today, the capital flood flowing their way ironically presents open-end fund managers with a potentially more daunting problem as prime real estate values have more than recovered since the 2008-2009 crash. The combination of low interest rates and investor -driven cap rate compression have sent prices in the coveted 24-hour cities to uncomfortable levels. It is an opportune time to sell marginal properties into the buying wave, but responsibly disposing of cats and dogs only adds to the portfolio manager challenge for meeting client commitments on the queue wanting into the funds.
Of bigger concern is whether to keep buying and even entertain “safe” development deals in the favored urban centers or venture into what amount to non-core secondary markets, which have not recovered and suffer from chronically tepid tenant demand. Any way you slice it, managers must come to terms with the obvious reality—there is just not enough core real estate to satisfy capital demand. And if they force money out or fail to sell underperforming properties, returns could be sorely compromised when the cycle turns against them in another recession.
Now you could argue with some confidence against a near-term recession. The U.S. economy strengthens anemically in fits and starts, unemployment edges down, consumer spending improves, and vacancy rates decline ever so slowly. Europe doesn’t look so sick, China will obfuscate its problems to allay market concerns and buy more time. Our re-found energy independence is a boon. It all adds up to more of the same—turtle speed growth.
But office and retail tenants shrink space requirements—companies and their executive suites make more by limiting their hiring, using less space, taking advantage of technology, and utilizing lower cost offshore markets to their advantage. More people work and shop from home. Demand for space is not robust except for apartments in the favored urban locations—foreigners look to park money while boomers and Gen-Yers surge in.
So under the circumstances if you are a wise core portfolio manager—
You sell those dogs and very selectively buy in the better markets where you have been concentrating your activity all along. You resist the temptation to push money out to satisfy investors on the queue. Certain build-to-core projects may make sense, but again only in the prime 24-hour markets with the best locations. Remember whenever you get in the vicinity of completing deals at 5% cap rates you know it is time to back off. And stay out of the suburbs and thinly tenanted secondary markets where demand never holds up. Clients on the queue may get frustrated, but where else can they put their money comfortably, and won’t the portfolio manager and his/her fund have a better chance of reaping long-term benefits for responsible stewardship and outperformance?
Or a portfolio manager can work down the queue quickly, swallow hard and rationalize overpaying, stretch the core envelope into some development or re-development deals, scope out retirement by 2017, and make sure his/her compensation package is tied to all those recent client inflows without any claw backs for under performance. “Hey clients first, I’m putting their money to work.”
The easy money has been made—now we’re down to tough choices.