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Item 602A
Real Estate - Revision to UCRP and GEP Asset Allocation Benchmarks
Committee on Investments / Investment Advisory Committee
April 22, 2003
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Recap of 3/4/03 meeting points
Pension funds/endowments/other tax-exempt investors, who invest in real estate, invest/target 5-9% of assets in public and/or private real estate
Real estate represents ~ 8% investment universe
Real estate’s historical total return and risk between U.S. stocks and bonds
Real estate has low cross-correlation with other asset classes = diversification benefits
Real estate has high % of total return in current cash yield – important for pension funds and endowments to meet cash obligations and needs
Real estate potential hedge against unanticipated inflation
Addition of real estate can improve portfolio return and lower risk under various investment scenarios
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Favorable Historical Return and Risk
Real Estate IndicesNAREIT (public REITs)NCREIF (private “Core”) – risk understated due to appraisal smoothing
Market Indexes10 Year Return-Risk Scatters
Ended 12/31/2002
NCREIF Property
S&P 500Russell 3000 Russell
2000
S&P 500Utilit ies
LB ITCredit
SB 10-YrTreasury
Timberland
Cash
NAREIT-Equity
0.0
2.0
4.0
6.0
8.0
10.0
12.0
0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 18.0 20.0 22.0 24.0
Risks (Std Dev)
Ret
urns
(%)
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Public vs. Private Strategies
Public strategy (focus on publicly-traded REITs)Liquidity and real time pricingBenefits from public market oversight and transparencyLow transaction costsInstant diversificationEase of buy and sell decisionsGood alignment of investor and management interests
Private strategy (limited liability investment vehicles, such as limited partnerships, LLC’s, private REIT etc.)
Opportunity to take advantage of private market inefficienciesOpportunity to purchase assets not available publiclyLower correlations with stocks and bonds than public real estateEven better alignment of interests provided sponsor has invested significant portion of personal wealth Investor can have some influence on management’s major decisions
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Private Strategies - Varied Return-Risk Objectives
Good long term potentialProperty specific problemUnder-managed assetAbout 50% of income from existing leases Remaining 50% of space requires leasingLeverage 50-70%
Good long term potentialLess than 50% leasedMajor asset re-positioning requiredMajor financial re-structuring requiredLeverage 50-70%
Security of Income Growth-Oriented
Risk
Return Value-Added
Opportunistic
RisklessRate Class A or B buildings
Good to excellent conditionOccupancy @ market level Creditworthy tenantsMajor geographic marketsLeverage up to 50%
Core
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Recommended Real Estate Allocation
Total Real Estate: 5% UCRP and 5% GEP
Lower end of 5-9% among peers who invest in real estate
Sourced by reducing U.S. stock allocation target by 300 bps and fixed income by 200 bps
But the maximum permitted stock and fixed income %’s remain unchanged because real estate target allocation will take time to complete
Wilshire Associates supports recommendation
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Total Portfolio if target benchmarks approved
UCRP Asset AllocationCurrent Policy Policy After Adding Real Estate
U.S. Equity 53% 50%Non-U.S. Equity 7% 7%Fixed Income 30% 28%TIPS 5% 5%Private Equity 5% 5%Real Estate 0% 5%
100% 100%
GEP Asset AllocationCurrent Policy Policy After Adding Real Estate
U.S. Equity 45% 42%Non-U.S. Equity 10% 10%Fixed Income 30% 28%TIPS 0% 0%Private Equity 10% 10%Absolute Return 5% 5%Real Estate 0% 5%
100% 100%
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Real estate in UCRP: risk-adjusted portfolio return improves
UCRP
UCRP 2003
4
5
6
7
8
9
10
0 5 10 15 20 25 30 35Expected Risk (%)
Exp
ecte
d R
etur
n (%
)
UnconstrainedFrontier
0% TO 100%
UC ConstrainedFrontier WITH real
estate
UC Constrained Frontier WITHOUT real estate
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Real Estate in GEP: risk-adjusted portfolio return improves
GEP
GEP 2003
4
5
6
7
8
9
10
0 5 10 15 20 25 30 35Expected Risk (%)
Exp
ecte
d R
etur
n (%
)
UnconstrainedFrontier
0% TO 100%
UC ConstrainedFrontier WITH real
estate
UC Constrained Frontier WITHOUT real estate
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Impact on Portfolios
Current Policy Policy After Adding Real Estate
Return Risk Sharpe Ratio Return Risk Sharpe RatioUCRP 7.15% 12.07% .34 7.17% 11.89% .35GEP 7.43% 12.67% .35 7.45% 12.50% .36
Conclusion: Allocating 5% to real estate improves risk-adjusted returns
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Recommend Dual Public and Private Strategy
Why?Public and private real estate are virtually uncorrelatedLiquidity of public strategy can offset lack of liquidity of privatePublic market is lead indicator of private market conditions Provides an opportunity to actively and easily tilt the overall real estate exposure toward public or private strategy depending on relative valuations in the public or private markets (Is real estate cheaper on Wall Street or Main Street?)
Public Real Estate: target 40% (range 30-50%)Underweight vs. private since some (.25 - .80%) of total portfolio assets will be invested in public real estate through U.S. stock portfolio; REITs represent about 1.6% of Russell 3000 Index
Private Real Estate: target 60% (range 50-70% )Overweight vs. public given potential superior return-risk profile vs. public40% Core (range 30-50%) 60% Value and Opportunistic (range 50-70%)
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Examples of Investments
Public StrategyPublicly-traded real estate investment trusts (REITs)
Private Strategy Limited partnership with other like-minded limited partners where partnership invests in office buildings Limited partnership interest where general partner is a public REIT that invests in industrial propertiesCommon stock in an Limited Liability Corporation (LLC) that would own retail propertiesCommon stock in a private REIT that is formed to own apartment buildingsPurchase, in the secondary market, an existing investor’s limited partnershipinterest in a partnership
Private strategy does not involve purchasing 100% (or less) of assets directly in name of The Regents or entering into “separate accounts”where assets are purchased by sponsors on behalf of TheRegents.
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Real Estate Portfolio Construction
Recommended Real Estate Allocation
$ invested @ full allocation and assuming no change in overall portfolio value
Number of Managers (Public) and Sponsors (Private)
$ invested per Manager or Sponsor
Number of Investments
Public Real Estate
2% (40%) 5 $135 M NA
UCRP $600 M GEP $80 M Private Real Estate
3% (60%) 10-15 $70-100M 20-30
UCRP $900 M GEP $120 M Total 5% $1,700 M
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Item 602B
Real Estate Investment Process and Portfolio Guidelines
Committee on Investments / Investment Advisory Committee
April 22, 2003
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Real Estate Consultant
Russell Real Estate Advisors retained conditional on Regents’ approval of investing in real estate
Established in 1971; office located in San Diego
Experienced team of 12 professionals with many years of service w/ firm
Good blend of mid/large sized and public/private client base with real estate assets totaling $35 billion
Extensive property market knowledge and database
Strong research capabilities
Services: portfolio construction and strategy advice, due diligence services, portfolio analytics, program oversight, and investment structuring
Wilshire Associates and Russell support the recommended investment process and guidelines
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Implementation of Public and Private Strategy
Investment Philosophy
Investment Return Objective
Investment Process
Portfolio Construction (reviewed in Open Session Item)
Portfolio Guidelines
Portfolio Benchmarks
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Public Strategy – Investment Philosophy/Objective
Investment PhilosophyInvest primarily for the long term
Focus on larger, more liquid securities
Invest in companies with sustainable cash flow that can grow andsupport the dividend pay-out
Invest in companies that act in shareholder’s interests
Reasonable valuations with focus on Net Asset Value (private market value) per share
Investment Return Objective5% real rate of return
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Public Strategy – Process
Hire external managers selected thorough due diligence process focusing on the following criteria:
ExperienceClear and sustainable strategyTrack record of superior performance and relatively low volatility with little or no leverageRisk management procedures and controlsClient service and operations, including researchTrading capabilities
Detailed due diligence process similar to that used for absolute return strategy
Hire independent consultant to perform parallel due diligence processStaff and consultant must concur prior to manager selection
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Public Strategy Process
Report to Investment Committee and Investment Advisory Committee
Reject
Reject
Screen manager to meet minimum criteriaReject
RejectInitial consideration by Treasurer’s Office
Consultant Initial Review Treasurer’s Office Further Review
Reject Accept Reject/Track
Prioritize for Due Diligence
Consultant Due Diligence Treasurer’s Office Due Diligence
Review by Treasurer’s Office Real Estate CommitteeCo
Manager contract negotiated and investment made
Reject Reject/Track
Approval byTreasurer’s Office
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Public Strategy – Guidelines/Benchmark
Minimum 90% must be in benchmark; up to 10% in other G-10 countries
No property type may exceed 2 X its benchmark weight
Individual security not more than 3 X its benchmark weight
Individual security not to exceed 5% of equity market cap
No investment with single manager can represent more than 25% ofthe public real estate portfolio
No investment with any single manager may exceed 25% of that manager’s total assets under management
Benchmark – Wilshire REIT Index
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Private Strategy – Investment Philosophy/Objective
Investment PhilosophyInvest for the long term, although select sponsors with a sell discipline
Emphasize alignment of interest by requiring meaningful sponsor co-investment and not merely asset accumulation
Invest through limited liability investment vehicles
Appropriate governance mechanisms
Investment Return Objective5% real rate of return
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Private Strategy – Process
Hire sponsors selected thorough due diligence process focusing on the following criteria:
ExperienceClear and sustainable strategyTrack record of superior performance and relatively low volatilityRisk management procedures and controlsClient service and operations, including researchAcquisition/Disposition/Asset Management capabilities
Detailed due diligence process similar to that used for private equity strategy
Hire independent consultant to perform parallel due diligence processStaff and consultant must concur prior to manager selection
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Private Strategy Process
Report to Investment Committee and Investment Advisory Committee
Reject
Reject
Screen sponsor/investment to meet minimum criteria Reject
RejectInitial consideration by Treasurer’s Office
Consultant Initial Review Treasurer’s Office Further Review
Reject Accept Reject/Track
Prioritize for Due Diligence
Consultant Due Diligence Treasurer’s Office Due Diligence
Review by Treasurer’s OfficeReal Estate Committee
Investment agreement negotiated and investment made
Reject Reject/Track
Approval by Treasurer’s Office
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Private Strategy – Guidelines/Benchmark
Limited Liability Investment VehiclesPrimarily equity-orientedProperty type
Office: 0-50%Industrial, retail and multi-family: 0-35% eachOther: 0-10%
Minimum 80% U.S.; maximum 50% in any one U.S. geographic regionNo investment more than 50% of total capital being raised No more than 25% of private real estate portfolio can be invested with a single sponsor or related sponsorsPortfolio cannot exceed more than 25% of a sponsor’s, or group of related sponsors’, total equity under management“Core” target 40% (range of 25-75%); “Value” and “Opportunistic” target 60% (range of 25-75%)Sponsors of “Value” and “Opportunistic” funds must meaningfully co-investLeverage may not exceed 50% of market value of all investmentsBenchmark – NCREIF Index
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Ongoing Monitoring of Managers/Sponsors
Necessary to regularly reaffirm the original investment decision
Internal risk and return expectations will be established at time of investment so managers/sponsors can be evaluated
Portfolio characteristics will be examined over time to review guideline compliance and examine for style drift
Investment staff will conduct frequent meetings/calls with managers/sponsors and periodically inspect assets
Establish criteria for placing managers/sponsors on watchlist or potential termination
Risk management staff will provide independent risk oversight function (establish risk measurement and monitoring procedures, minimum data requirements, etc.)