Lead Story…. A few months ago, I was having lunch with a friend who works for an allocator that has a large private equity fund as an LP. His business is to deploy and manage capital for the LP (the private equity fund) in the residential development space. The conversation primarily focused on how difficult it was to keep LPs interested in the space since returns were not meeting expectations portfolio-wide. This is a common problem that I’ve heard from investors in the residential development and construction segment of the market in recent years – the are under-performing almost across the board – even while investors with a commercial value-add focus rack up returns that often exceed underwriting. Yes, values have gone up substantially but cost increases and timing delays have been even more substantial. That being said, this genuinely seems like an issue of unrealistic expectations to me. After all, the “subpar” returns that my friend and others referred to were in the mid-to-high teens from an IRR perspective, which sounds really good until you realize that the projects were initially underwritten to perform somewhere in the mid 20s.
Interest rates have been in long term decline for decades, meaning that both the cost of debt financing and returns on “risk free” assets have also been falling. It would stand to reason then that projected returns for opportunistic real estate plays like development and construction would fall as well. However, that has typically not been the case as the mid-20s IRR target has remained largely unchanged over the years as rates have plunged. Today I want to take a closer look as to why this is.
To make sense of this puzzle, you have to look away from fundamental analysis – which largely dictates that the premium for an opportunistic investment like development should be a spread over the risk free rate of return – and take a closer look at the market forces emanating from large investors that force LPs such as private equity funds to target largely unrealistic returns. Generally speaking the largest investors with some of the most clout in this space are pension funds, and pension funds are facing a massive problem that they are incredibly ill-positioned to deal with in today’s low return environment – funding shortfalls. Pension funds have to match liabilities in order to ensure that they have adequate capital to pay out to their current and future beneficiaries. In order to do this, they have to make assumptions about future returns and this is where the problems really start. Heather Gillers of the Wall Street Journal wrote about the challenge of generating adequate returns in a low yield world in the Wall Street Journal last week (emphasis mine):
In the public pension world, the willingness to chase expensive assets is the product of the core challenge most funds face—how to fulfill their mounting obligations to workers and retirees.
Decades of low government contributions, overly optimistic assumptions, overpromises on benefits and two recessions have left them with deep funding holes at a time when retirees are accelerating cash outflows. Estimates of their current combined funding shortfall vary from $1.6 trillion to $4 trillion.
The goal of most pension funds is to pay for future benefits by earning 7% to 8% a year. After the 2008 financial crisis, many funds tried to hit those marks by lowering their holdings of bonds as interest rates dropped, and by turning to real estate, commodities, hedge funds and private-equity holdings.
These so-called alternative investments rose to 26% of holdings at about 150 of the biggest U.S. funds in 2016, according to the Public Plans database, compared with 7% more than a decade earlier.
If you think that the idea of generating 7% – 8% annual returns in a well-balanced portfolio at a time when the 10-year treasury is yielding around 2.5% is nonsense, then you are correct. Michael Batnick at The Irrelevant Investor wrote a follow up to the Wall Street Journal story called The Math Doesn’t Work that used CalPERS as an example of just how delusional return projects currently are (emphasis mine):
The Wall Street Journal reports that Calpers, which currently has $341.5 billion in assets, has a target allocation of 50% to stocks and 28% to bonds, leaving the remaining 22% invested in things like real estate, private equity and other alternative investments. With stock valuations and interest rates where they are, and a target return of 7%, it’s probable that some tough decisions will need to be made in the coming years.
If we assume that stocks do 5% a year for the next decade, and bonds return 3% over the same time, then the third bucket would need to generate 16.6%, net of fees, to hit the 7% bogey. And if we do enter an environment where stocks do 5% and bonds do 3%, then the chances that $75 billion (22% of $341B) can generate returns of 16% is slim to none.
So the broad “hope and pray” strategy in place here is to assume that stocks and bonds will basically return what the market will bear (it’s difficult to out perform broad indexes when you have hundreds of billions in assets) and then hope that the alternative assets in the portfolio perform incredibly well. However, most of the alternative assets that pension fund hold are not opportunistic in nature since that would represent too much risk. In real estate, for example, the vast majority of a pension fund portfolio would typically consist of core and core plus assets that generate IRRs of roughly between 6% and 12%. Considering that they need to generate 16+% net of fees, it’s not difficult to see why pension funds are still demanding mid-20s IRRs on residential development even though the market as a whole can’t sustain it.
Private equity continues to pitch LPs (often pension funds) that they can generate high returns across a development/opportunistic portfolio. Why? Because they have to. If one private equity firm lowered their return projections, their competitors would simply swoop in and maintain the high projections anyway and, in telling the pension fund what they wanted to hear would likely win the business. Also keep in mind that the private equity fund’s promote is based off of the high return projections. If projections are missed, they fall out of the promote promote so there is little incentive to allocate more capital to the space even if total returns are actually good compared to alternatives. This puts pressure on operators to be overly aggressive with underwriting assumptions in order to show adequate returns but ultimately leads to under-performance if everything doesn’t go right. The aggressive underwriting inevitably puts pressure on every level of the deal structure since everyone from the Sponsor to the allocator to the private equity manager has their economics tied into projections that are often un-achievable. As a result, several private equity funds have ditched their allocators in the residential development space and started providing capital directly to sponsors. However, this can come with it’s own pitfalls since the funds are often understaffed to handle the level of asset management that this requires.
The obvious solution here is to make projections consistent with what the market will bear for managers across the board but that would require pension funds admitting en masse that they have been hiding the weenie for years in terms of the size of their deficits and they clearly aren’t prepared to do that. So instead we muddle through with everyone pretending that opportunistic returns are the same in an environment where the 10-year is yielding 2.5% as they were in an environment where it was yielding 10%, leading to inevitable disappointment since expectations are simply too high. I’ve been critical of private equity as a source of equity capital for real estate development projects for quite a while. It’s not a particularly flexible investment vehicle and the returns that are needed in a multi-promote structure typically only work for a relatively brief time when the proverbial blood is in the streets. Unfortunately, in today’s market there just aren’t that many options outside of private equity for real estate projects of a relatively large size. I remain hopeful that a new sort of investment vehicle will fill the void but we are not there yet.
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