Instead of purchasing directly an income-generating building, one could alternatively purchase the shares of a non-listed collective investment vehicle (aka fund). This information-packed webinar provided a broad overview of the fund management process and the role of the fund manager, specifically applicable to real estate funds. The webinar equips you with an understanding of the risks and reward of investing in a real estate fund, the challenges of setting up a fund and the characteristics of modelling the performance of a fund.

Client Investment Objective

Real Estate fund management begins with determining the client’s investment objectives, usually laid out in the Investment Policy Statement (IPS). Investment objectives and constraints can be decomposed into three key areas. Firstly, return objectives, that are either an absolute (e.g. CPI + 2%) or a relative target i.e., a benchmark (e.g., MSCI All-property). Investment constraints include the time horizon that might be either one-year, rolling three-years, or intergenerational wealth preservation.

Secondly, risk objectives relate to the risk tolerance of the client. The client’s specified level of risk tolerance can be stated in absolute terms (maximum loss they’re prepared to take) or relative terms (degree of underperformance against a benchmark).

Thirdly, a key investment constraint is the liquidity requirements of the client. For example, Malcolm explains that clients may want their money back over a relatively short period, or they might be happy to leave their money with you for a very long time. Understanding the client’s liquidity needs and time horizon is crucial for a relatively illiquid asset class such as real estate, especially when it concerns direct property investment. Thus, Malcolm stresses that it is vital to be aware of the client’s liquidity needs and your ability to meet those requirements.

Implementing Strategy:

Next, Malcolm details the execution stage of fund management breaking it up into four principal strategic areas. Firstly, there is asset allocation. Specifically, this relates to allocating more capital to sectors that are expected to outperform. Secondly, within asset allocation, you then have stock selection. The purpose here is to select/acquire property in each of the sectors expected to outperform that sector. A third way of outperforming is through active asset management, where you use superior property and asset management skills to achieve a higher return. Finally, fund managers can use leverage to increase the magnitude of returns. Leverage is simply the use of debt/borrowed funds, and it amplifies the returns on an investor’s capital, both upwards and downwards. Therefore, while your return may increase, so will your risk. The IPS will detail whether or not leverage can be used in a client’s portfolio.

Investment Philosophy

As Malcolm describes, the skills or competitive advantages you have, as a fund management house, will feed through into which strategy you undertake. For example, if you believe that you can select markets that will outperform or time your investment through a cycle, you’re more likely to choose asset allocation.

Furthermore, Malcolm goes on to clarify that many, “real estate investors staunchly believe that leverage is the key to delivering high performance.” However, in recent years, leverage has been damaging to property performance, particularly through the 08 financial crisis. Ultimately, using leverage to magnify returns comes with greater risk that investors should be willing to bear.

However, regardless of which philosophy or skill set you have, one concept will contribute to delivering the client’s investment objective—specifically, diversification. Diversification is about risk reduction. Diversifying the risks of a portfolio helps reduce downside risk without necessarily decreasing the expected return. Correlations between different assets can lead to decreased overall risk when combined. The principle behind the diversification effect is based on Harry Markowitz’s research, known as Modern Portfolio Theory. Therefore, regardless of your means of achieving the investment objective, if you allocate your portfolio across different sectors of the market (retail, offices, industrial), and assuming they’re less than perfectly correlated, you can minimize your risk for a given level of return.

Building your own investment strategy

Next, Malcolm walks through the steps of building your own investment strategy to achieve an investment objective. First, you need to decide on your return objectives, stated in relative or absolute terms. In Malcom’s case, he uses a relative return target (e.g., MSCI All Property Index) to outperform it by 0.5% per annum. Equally as important is deciding on the time horizon. For example, the rolling three-year periods used by Malcolm, with his level of risk set to underperform by not more than 0.25% per annum.

Regarding liquidity constraints, Malcolm sets his as to be able to withdraw 10% of the fund value at three months’ notice. These investment objectives and constraints can be tabulated with your risk and return of capital invested subdivided within asset allocation, stock selection, and asset management. For example, you will have to decide how much of your 0.5% return you want to be delivered through asset allocation or stock selection. Moreover, how much leverage are you willing to use to magnify your returns while still ensuring you do not exceed your risk tolerance. Once again, it essential to remember the linear relationship between risk and return. That is, while leverage may increase your return, it also comes with higher risk.

Moreover, the borrowed funds will come at a cost i.e., margin interest. The higher the level of leverage, the higher your margin loan interest, which can reduce your return. These are all pertinent issues to be aware of when building your own investment strategy.

Case Study 

To conclude, Malcolm presents a case study of a REIT fund management strategy (Real Estate Investment Trust). Usually, with REITS, or listed property companies, it is unusual to see any stated investment objective. The presumption is that you’re trying to get the market returns if you’re a listed property company. This specific REIT details it’s strategy as aiming “to buy assets when values are falling or low,”— i.e., they believe that you can time the market. The statement goes on to further say that they, “start to develop early in the cycle, work closely with customers during their leases, and sell assets at appropriate points in the cycle.” Simply put, they believe the best way to get the maximum returns is to undertake active management through development early in the cycle. In addition, they also indicate that they will work closely with their customers during their leases, presumably to achieve a higher tenant retention rate and ultimately greater returns. In sum, the strategy aims to buy low, sell high, incorporate development, active management and time their development at the start of the cycle.