The Hassle—and High Potential—of Direct Real Estate

From aiCIO magazine's April issue: Is the direct model only reserved for "top-tier" institutions? Sage Um reports.

View this article in digital magazine format.

“Most of our real estate investments today are made directly in individual properties, rather than via participation in commingled funds,” says Joe Fazzino, senior manager for the $43 billion retirement fund for United Technologies (UTC), a Connecticut-based company for aerospace products and services. Interestingly, he says the financial crisis awakened UTC to the risks of not going direct: Those heavily invested in real estate via funds or fund-of-funds took a hit from dislocated prices and liquidity problems.

“Commingled funds were reluctant to sell properties in a soft market, while at the same time, there were fewer new investors whose investments could have been used to provide liquidity for those wanting to exit,” Fazzino recounts. UTC overhauled its strategy after that experience, in an effort to rectify liquidity restrictions.

Sizable direct investments are particularly well suited to corporate pension plans, which enjoy increasing liquidity as they de-risk.

UTC, with the help of real estate management firm AEW Capital Management, invests primarily in multifamily properties, aiming to capitalize on demographic shifts, urbanization, and trends around home affordability in urban centers—a successful strategy so far, Fazzino says. Although still slightly underweight its 6% target allocation—largely due to portfolio repositioning—UTC committed $200 million last year to three urban multifamily development programs through a separate account with AEW. New, large-scale residential buildings are planned for Jersey City, Boston, and Seattle.

“We believe that the primary benefit of direct investing is the ownership control that it provides,” Fazzino explains. “As a direct owner, we can customize investment strategy, guidelines, debt levels, and the pace of investments and property sales.” By actively choosing where and what to invest in, asset owners may be able to stack their portfolio more dynamically and better hedge against inflation—often a key function of real estate assets. Specific and targeted decisions land with the investor, not a general partner.

But targeted direct investments don’t come easy, says Tim Walsh, president and COO of real estate fund manager GAW Capital Partners USA, and former investment director of New Jersey’s $74 billion pension plan. Typically, investors can save on expenses through direct investing, he says—if all the proper staffing, infrastructure, and governance are in place. Without these features, the cost-benefit prospect of going direct can be tricky to reconcile. “It’s a lot easier—and somewhat cheaper—to make an investment in a fund as a limited partner [LP] than it is to actually buy a specific commercial building,” Walsh explains, speaking as one who has done both. “These direct investments, or separate accounts, require more staff and consulting support. There’s a lot more work to set up at the onset than you would face as a traditional LP. There is more legal detail and generally no cookie-cutter format to follow. It takes a lot more time.” This is time—and resource drain—that many investors who lack UTC’s size simply do not have.

A 2012 paper by German researchers reinforces this position: Direct acquisitions and closed-end funds may not be effective for small- and medium-sized institutional investors. “The professional and in-depth knowledge of economic, legal, and technical relationships with real estate investments and the relevant markets can only be generated by larger institutions,” authors Steffen Sebastian, Melanie Wagner-Hauber, and Bertram Steininger wrote. Direct investments should only be made when savings made in due diligence processes in-house could offset high transaction costs. Instead, the authors argue that indirect investments such as listed property shares and real estate investment trusts are likely the most efficient vehicle for smaller funds. Accessing the asset class indirectly optimizes transaction costs, risk diversification, and the highest possible liquidity, they explain, by trading on the stock market.

On the opposite end of the spectrum, then, stands the giant Ontario Municipal Employees Retirement System (OMERS). “Three of the Canadian pension funds decided to play real estate through a direct platform,” says Eric Plesman, senior vice president of investments at Oxford Properties. “We think it’s been the right decision—absolutely.”

For Oxford, it undoubtedly has been. In 2001, OMERS acquired the commercial real estate firm Oxford Properties for $1.5 billion, transforming it into the $65 billion fund’s real estate arm. Today, it invests more than $24 billion on behalf of OMERS in a portfolio of “high-quality income-producing properties in world-class cities” in Canada, the US, and the UK. According to OMERS’ 2013 annual report, Oxford Properties slayed its 7.25% benchmark with a return of 14.3%.

The direct model also offers greater potential capital appreciation, says Plesman, which translates into alpha from above average gains on equity, or at least below average costs. “The general and administrative expense is more than offset by fees that we receive from tenants—and fees that we would otherwise have to pay a third-party manager,” he argues. Direct investments maximize returns through prospective increased property values, adding cash upon payout.

Still, Walsh points out that few institutions outside of the top-tier—OMERS, New Jersey, UTC—possess the “professionalism on the outside that you have on the inside with experienced general partners.” And this dilemma demands the question: Is it worth it? The answer, as it so often does with institutional investing, depends to an extraordinary degree on your priorities.