Demystifying the Drivers of Real Estate Fund Performance

Reporting performance and understanding it are separate challenges; by including simple additions to their reporting package, managers can help clarify the picture for their investors

For many real estate investment managers, performance verification is a highly scrutinized component of the reporting process. Investors desire a palpable indication that their invested capital is not only earning an acceptable return, but also that their investment manager is performing above replacement. 

While industry standards in this area have been present for years, performance reporting can still pose a murky picture. Investors must sift through variations in calculation methodologies, presentation standards, and benchmarks. In typical reporting packages, performance disclosure often leaves investors with false attribution of investment decisions at the property level. Transparency into this detail is often exclusively upon request, and only if the investment manager contributes to a performance index. 

Disclosing Performance Methodologies 
Within the real estate industry, standards for performance calculation and reporting requirements were developed as part of the Global Investment Performance Standards (GIPS) and further amplified by industry associations such as the Pension Real Estate Association (PREA) and The European Association for Investors in Non-Listed Real Estate Vehicles (INREV). Adherence to these guidelines for performance disclosure is a necessary part of the performance reporting process. 

Much debate has taken place within the investment management industry regarding Money-Weighted Returns (i.e. Internal Rate of Return (IRR)) vs. Time-Weighted Returns (TWR) as to which is the more effective performance calculation methodology. IRR has been the most common method employed by closed-end funds, while TWR is primarily used by open-ended funds. The lines can blur, however, as closed-end funds contributing to a performance index will likely receive TWR returns, while it’s common for open-ended funds to still report both TWR and IRR returns at the investment level, even if fund performance is calculated via the TWR method. 

Strides have been made within the industry to educate investors and investment managers on the differences between the two methods. The National Council of Real Estate Investment Fiduciaries (NCREIF), the primary institutional real estate performance index in the US, has suggested a standard reconciliation between the methods that could be provided as a reporting disclosure. Reconciliation of IRR and TWR methods is a noteworthy addition to a performance reporting package, especially for those investment managers that employ both methods. 

Demystifying Performance Attribution
Reporting performance and understanding it are separate challenges. Real estate investment managers are always fielding questions from investors regarding a fund’s performance and the drivers of it. Investment managers who contribute to performance indices – such as those managed by NCREIF and MSCI – are provided in-depth attribution reports that detail which properties, sectors, and regions contribute to over/underperformance relative to the benchmark. These reports are typically made available to investors upon request. 

While performance benchmark attribution reports are invaluable, they do require an understanding of TWR methodology noted above in addition to the concept of allocation, selection, and intersection scores. Investment managers can help clarify the picture for their investors with some simple additions to their reporting package. 

Understanding property-level drivers of fund performance is a matter of determining which properties ‘pull their weight’ and which do not. Fund-level return is a composite of individual property returns. In a scenario where perfect parity is achieved, each property would generate income and appreciation that is equal to its weighting of the fund Net Asset Value (NAV). However, in reality, properties will both pull more or less than their weight and thus have outsized or undersized contributions. Including property size contributions for income and appreciation in a standard reporting package would provide investors with an easy-to-understand set of metrics, which can help them quickly identify which properties drove performance for a given period.

Fig. 1 illustrates the impact of size contribution on real estate fund performance. Property A, for example is the fund’s greatest contributor toward its overall income return. From an investment perspective, Property A is approximately 42% of the fund’s NAV but contributed approximately 51% of the fund’s income for the same period. This is an outsized income contribution. The property income return for the period is simply the fund return multiplied by the ratio of property income weight to fund weight, or the ‘Size Contribution Factor.’ 

Fig. 2 illustrates the relationship between size contribution and return. Since Property A has an outsized contribution, its income return exceeds the overall fund return and so it’s a positive driver of fund income return. Properties C-E generate positive income, but their income-weighted return falls short of their fund-weighted return. While Properties C-E have positive income returns, their undersized contribution has a negative impact on the fund income return, lowering the number overall. 

Somewhat simplified illustrations such as property size contributions are a relatively easy addition to the performance section of any standard reporting package. These will add value by supplanting commonly asked questions around property-level performance drivers. 

Leveraging an Existing Industry Value Chain
Investment managers can hire independent firms to assist with the performance reporting process. Many firms in the fund administration industry provide a performance verification service. Independent oversight and verification of performance calculations is a best practice to signal transparency and integrity to investors. By nature of this, these service providers should also be called upon to help establish best practices for performance reporting and attribution. This will ultimately reduce variation in standards seen by investors across their own portfolio of investment managers, and further enhance the efficacy of investor reporting. 

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