Interviewed by: Zoe Hughes

March 9, 2015

The role of real estate has fundamentally changed a current investor’s perspective on diversification, making them more attuned to a wider definition of risk, says Courtland Partners’ co-founder Michael Humphrey. He talks to PrivcapRE about:

New Rules for Achieving Diversification

With Michael Humphrey of Courtland Partners

Zoe Hughes, PrivcapRE:  I’m joined here today by Michael Humphrey, Managing Principal and co-founder of Courtland Partners. Michael, thank you so much for joining me today.

Michael Humphrey, Courtland Partners. Thank you.

Hughes: Diversification is a critical component of every investor’s portfolio; however, in the wake of the crisis. it’s fair to ask how we actually achieve it in portfolios. Or. indeed, whether it’s even needed in real estate portfolios. Michael, you’re here to talk about some of the challenges that are actually facing investors, but first talk to me about why diversification is getting so much great attention.

Humphrey: Diversification has always been a part of risk mitigation. The question is whether the diversification we previously did was really meaningful, or meaningful enough. given the new global market conditions and the changes that have occurred. In the past, we used to talk about diversification for a number of our clients in terms of property type and regional diversification here in the U.S. Today. many of our clients have global portfolios; those global portfolios have exposure to property types other than the traditional property types and they also have exposures to markets outside the U.S.

Hughes: Is risk different today than what it was pre-crisis? Are there other types of risks that investors are concentrating on versus some traditional ones?

Humphrey: We sit here with a federal reserve in the U.S. with a $4 trillion balance sheet. We’re on the cusp of [Mario] Draghi in Europe following the same pattern or the same approach with a trillion — Euro quantitative easing program. We’re real estate people. These are new macroeconomic conditions. Mix that in with some of the political risk and you’ve got a new risk environment that we all have to be mindful of.

So. yes. I would say the first thing we realized after the great financial crisis for one of our clients. for example, they said, “We lost 10% of our portfolio value in one focused area. Come in and help us determine what caused that loss. We want an attribution analysis and we want to understand. where the risk was, what the loss resulted from and how we can look at things going forward.” It just so happened in that portfolio, there was a significant amount of investment in non-core, highly-leveraged mezz debt and other stuff that had a lot of leverage that got hit severely when values adjusted.

What wasn’t tuned into as much as it needed to be was that the mezzanine managers were leveraging their positions—sometimes with repo’ed debt.

Hughes: Leverage is a huge issue when it comes to trying to look at diversification within real estate portfolios. I mean, can you actually leverage or mortgage away diversification benefits by the use and application of leverage?

Humphrey: That leverage in the non-core potion of the portfolio was a primary risk after the great financial crisis. And you saw the value adjustments. At this time. though, we’re five years out from the great financial crisis and people are asking the question again. What’s interesting now is [that], if you look at the non-core exposures, you don’t see the same type of leverage, at least not yet.

Now. fast forward. We’re into an environment where we’ve had many years of low interest rates. So what’s happened for many of our clients, many of the big institutional investors in the industry have moved down the risk-return spectrum.

The concern is [that] there’s risk associated with that lower risk part of the risk-return spectrum. And one thing we’re trying to do is to tune into that and make sure we’re articulating that risk. Interest rates going up is one of the concerns, but it’s not that simple.

Hughes: Does this all come back to the role of real estate and investors changing their view as to what real estate means in that portfolio?

Humphrey: Absolutely. We have to acknowledge that there was some, if you will. style or creep within our policy formulation. There was an acceptance of a greater level of risk in real estate over the last 10 years that really started from the ‘90s—when we had the first emergence of the opportunistic funds and the success they had in investing in distressed debt and real estate-owned and other financial distressed situations.

The reality. though. is that after the great financial crisis, people reassessed what the role of real estate is. Is it cash flow? Is it preservation of capital? That has become a much more important discussion given that. because of this low interest — rate environment, real estate allocations have increased and the capital has typically come from places like fixed income.

Hughes: So. that focus on capital preservation, obviously income particularly but perhaps more playing in the core, core-plus space—how does that impact how you build your asset allocation models? Do you look at certain property types? Or has the whole conversation about how we achieve diversification changed because the role of real estate has changed?

Humphrey: Sure. No. that’s right. As we’ve come down the risk-return spectrum—there’s a variety of roles that real estate plays, right? Diversification for the total portfolio, inflation hedge as well as income and cash flow and total return; our value. I hope that we add with our clients is to help assess, “Which of those objectives are most important?” Once we can then prioritize those objectives, then we can begin to frame the risk-return of the total portfolio. What has occurred is that there’s been more of a focus on core. on leverage and other risk attributes. For example, asset size has been focused on because asset size really indicates a lot about the type of asset you own and the level of risk associated with it.

One of the larger, open-ended core funds. for example, has an average asset size of $190 million. They’re primarily invested in CBD office and large apartment properties and they’ve got significant exposure to New York City. Now. other open-ended core funds and a number of our clients with separate accounts will have average asset sizes of $45 to $50 million. Typically, those accounts are more secondary-market oriented and there’s a different level of risk then associated with that kind of exposure. So we’re spending time out with our clients right now and saying, “OK. We’ve increased the core allocation. Let’s start using some terminology to better articulate than the risk within that core allocation.” Senior mortgages, net lease, what we call a beta core and then core and core-plus are the different grades, effectively, we go through in assessing our client’s portfolios. There are different levels of risk and return and we need to tune into that.

Hughes: When we talk about diversification, does it also matter as to where the investor comes from?

Humphrey: No, absolutely. Over the last two years, we’ve picked up clients from Australia, from Japan and from Europe, and it’s really interesting to see their perspective. The first Northern European client we picked up, for example. has a pretty significant, multi-billion dollar allocation in real estate. And they’re a direct investor in real estate. They are (or they were at that time) exclusively invested in Europe. So the call was pretty interesting when they first talked to us. They said, “We need to diversify. We want some exposure in the U.S. We’re looking at the major markets; we’re looking at major properties.” And they had a building in New York City already in mind, right?

The other thing that’s happening that’s really fascinating is—we have a French client. for example. And when we started with them last year, we were benchmarking their returns when we were going through their strategy and we all agreed [that] it was an income-focused strategy. And we thought the most appropriate benchmark was a spread over the French 10-year. Now. we’d never tracked the French 10-year before. At that time, the French 10-year was 250 basis points. Today, it’s 50 basis points. It may even be lower after what Draghi’s done. But the bottom line is, it’s come at 200 basis points.

So now. we’ve got an investor with—if you apply a benchmark we came up with just last year—a three-cap, 3.5% or a 4% going in yield on a major property in New York City or San Francisco; it’s still a reasonable income return for them.

Hughes: Also, when you’re looking at trying to achieve diversification with a real estate portfolio, do investment structures and vehicles play a part in how you diversify that portfolio?

Humphrey: There was a big push amongst some of our clients to get more control. And that’s resulted in some of our clients moving from a pooled-fund focus—I mean. one of our large public — fund clients is …significantly pooled-fund exposed and. over the last 18 to 24 months they’ve put in place new policies where they’re going to focus more on direct investment. That’s to enhance their ability to control the investment, the manager, etc. That’s a theme we’re hearing.

Now. the question from a diversification standpoint, of course, is that portfolio is a lot lumpier than the pooled fund exposure. And we’ve done a lot of analysis of some of these separate accounts recently for our clients to really help them unpack that level of risk. Because the bottom line is, even if you have a billion-dollar allocation to real estate and you put 60% of 70% of that into separate accounts, in order for you to get diversified by property type across the four major property types and across the regional markets within the U.S. you’re really stretched. Then, you can’t really go buy that larger asset. You can’t go buy that $200 to $500 — million asset. Or least you can’t do it very often because it just eats up too much of your allocation and then your portfolio is too lumpy. And that’s a great deal of risk.

That’s the challenge. So what we’re doing going forward is finding the mix of direct investment. It’s not just separate accounts. It’s also through programmatic joint ventures in real estate operating companies, but finding that mix with a pooled fund exposure to give you the diversification you need and the control.