As institutional investors flock to real estate, investment managers must avoid getting stuck in the middle of the market—too big to be nimble yet too small to reach scale.

Real estate is one of the largest alternative asset classes thanks to $3.1 trillion in assets under management (AUM). LP allocations nearly doubled from 5 percent in 2005 to 9 percent in 2017 and sustained, high single-digit growth in AUM has been driven as much by investor appetite as by strong asset-class performance.

The perception of equity-like returns, lower correlation with broader capital markets and relatively high cash yields, has seen investors flock to the asset class.

LPs remain underweight relative to long-term targets, and the sector continues to enjoy a structural tailwind. Few managers are well positioned to meet their evolving needs and to give LPs confidence in alpha generation at a time when capitalization rates are low.

Surveys indicate that many LPs expect to increase their allocations to managers they trust, and capital appears likely to continue flowing from new sources.

How exactly are the needs of LPs evolving?

Risk off, yield up

LPs have traded down the risk spectrum in the years since the global financial crisis. One likely reason could be the search for yield, as many investors have rotated away from sustained low yields in traditional fixed income.

Even with prime yields for Class A office space falling as low as 3 percent, core real estate has provided a 200- to 400-basis-point spread over ten-year Treasuries (and also did well through the last downturn). While that has attracted much interest, lower expected returns in core strategies, driven by compressed cap rates, have prompted a shift to core plus.

For LPs, core plus might be said to combine the yield of core with the opportunity to outperform the leading benchmark referenced by most pensions and their investment teams.

Long-term capital deployment

Open-end funds have grown at 18 percent annually in the past five years, as GPs have favoured capital without a set hold period. Their share of core and core-plus investment grew from 21 percent to 28 percent during that time.

In keeping with the broader shift across most private markets, the traditional drawdown vehicle has lost ground to more flexible structures.

Private equity–style closed-end structures are not dead; indeed, fundraising has recently accelerated, particularly for opportunistic funds. But the permanent nature of open-end vehicle capital and incremental cash flow over time have led to greater share for these vehicles.

Growth in direct investing

Many larger, at-scale LPs have built in-house capabilities, increasing control and discretion through separate accounts, discretionary sidecars, coinvestments, and direct investment through large-scale joint ventures (JVs).

Others are tying up with operating companies, either by buying them outright or by investing through exclusive agreements. By increasing allocations to more-direct strategies, LPs both lower their costs and retain greater control over decision making and cash-flow timing—both attractive attributes.

Many large LPs will continue to invest in funds and look for partners that can service their full range of needs (such as one-off development JVs). Smaller LPs (which represent the majority of capital) still rely on commingled funds.

Net returns, not just gross returns

LPs are looking for ways to get exposure to real estate but will only pay for higher cost structures that also deliver consistent alpha. While some managers are meeting that need, the push for lower costs has led to rapid growth in AUM of several very large investment managers (IMs)—most notably, funds sponsored by insurance companies and traditional asset managers, both of which often benefit from balance-sheet capital and in-house distribution networks.

These embedded advantages provide scale economics to these players, allowing them to compete with relatively low fee structures (typically without a promote). As these investors grow larger, and the institutional-investment landscape grows increasingly fee averse, managers with higher cost structures will be further pressed to justify their fees through differentiated value propositions and proven ability to outperform through cycles.

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