Investors play waiting game on valuations

Some private capital fund managers are marking down portfolios more in line with public market prices, while others have yet to do so.

Institutional investors are waiting with trepidation and a little hope for markdowns, and seeing a wide dispersion of performance in their private market assets, particularly real estate, because managers differ in their approach to pricing. A wide range of returns can be seen within the same asset class and similar investment strategy.

While most expect investors' private capital portfolios in real estate and private equity to eventually be written down between 10% to 15%, investors won't know for sure for a year, or maybe longer.

"I don't think I've seen a year where we've seen such a dispersion of returns within asset classes," said Molly Murphy, CIO of the $20 billion Orange County Employees Retirement System, Santa Ana, Calif., at the Feb. 22 investment committee meeting.

Ms. Murphy said all of their private market managers will get audited "and that is what we are waiting for. ... Auditors will hold them to legitimate valuations as opposed to optimistic valuations."

The differences have less to do with how assets and properties are performing and more to do with how managers value those assets and price them, said Stephen P. McCourt, San Diego-based managing principal and co-CEO of consultant Meketa Investment Group Inc., speaking at the same meeting.

"There's some realization of reality that hasn't happened yet," Mr. McCourt said. "The most significant departure from reality is real estate and different sectors experienced that in different ways."

OCERS is not alone.

The $42.4 billion New Mexico State Investment Council, Santa Fe, should expect its real estate portfolio returns to fall over the next few quarters, said Seth Marcus, a partner at real estate consultant Townsend Group, at the council's Feb. 28 meeting.

The council's $4 billion real estate portfolio earned a net internal rate of return of 19.2% for the year ended Sept. 30, which Mr. Marcus said was "significantly above expectations and historical norms" of 7% to 9%.

Real estate lags the broader markets, which have already declined, by 12 to 18 months, he said.

Townsend expects write-downs in the fourth quarter and into 2023, Mr. Marcus said. He said that the council's real estate investments could experience a -5% IRR in the fourth quarter.

Townsend expects real estate returns to continue to be negative and its outperformance to narrow into 2023 as private market assets are revalued.

Across property types, office and industrial were the lowest performers in the fourth quarter, Mr. Marcus told the council. There were also write-downs in stronger sectors such as medical office and life sciences.

Retail was down only slightly due to write-downs that were already taken starting before the pandemic, he said.

Asset type matters, and so do the managers' valuation methodology and whether managers sponsor open-end or closed-end funds.

Just among open-end fund managers, valuation processes differ, said Catherine Marcus, a managing director, global chief operating officer and head of the U.S. equity business at PGIM Real Estate.

For example, the majority of PGIM Real Estate's products are valued by a third party every quarter. Other open-end fund managers get a third-party valuation once a year and do internal valuations the remaining quarters, she said.

Still, other open-end fund managers do a one quarter external full appraisal with an external firm reviewing the internal appraisal the other three quarters, Ms. Marcus said.

Fund managers who use external appraisals of their properties every quarter will adjust their portfolio values more quickly than managers who obtain an external appraisal one quarter a year, Ms. Marcus said.

A single valuation standard would make it easier to compare returns, she said.

Most closed-end funds are valued once a year, Ms. Marcus said. In some respects, it is less important with a closed-end fund because, other than the real estate secondary market, investors aren't trading on the information, she explained.

However, investors need the information to know how to report the progress of their portfolios, Ms. Marcus said. And open-end funds offer more liquidity to investors.

Real estate managers use different forward-looking assumptions when they place a value on their portfolios, and this can create dispersion in reported returns, said Warren Wachsberger, CEO of AECOM Capital, a $4.2 billion real estate fund manager based in Los Angeles.

Recent fund vintages have more "noise" in the form of different valuation methodologies, he said.

It takes longer to arrive at the "true" value of properties when transactions grind to a halt, Mr. Wachsberger said.

What's more, there are more conservative managers and more aggressive managers, he said.

"The mean return is probably right," Mr. Wachsberger said. The NCREIF Fund Index – Open‐end Diversified Core Equity lost 5.17% in the fourth quarter, down from a 0.31% net return in the prior quarter.

Dags Chen, New York-based managing director and head of U.S. real estate research and strategy at Barings, said the office sector "is driving much of the debate around property valuations."

Not only is the office sector facing higher interest rates but there's also been a dramatic reassessment of underlying demand for office, Mr. Chen said.

When lease renewals come up, tenants are seeking less space, reducing revenues of a lot of office properties, he said. At the same time, costs are higher as lenders are demanding higher risk premiums.

"It's a perfect storm of bad events," Mr. Chen said.

"What we've been trying to do at Barings is be very transparent with investors and to let them know at the very least what we expect," he said.

"Historical performance of real estate no longer applies," Mr. Chen added. Barings is writing down its office properties by 30% since the start of the pandemic, even though the property-level performance has not changed, Mr. Chen said. As of the fourth quarter, 85% of Barings' $1.9 billion worth of traditional office properties in major metropolitan areas are occupied, he said.

"It is a recognition that there has been an undeniable shift in the demand for traditional office that will impact cash flows," Mr. Chen said.

Meanwhile, appraisers are holding onto past real estate values because there has been no meaningful arm's-length transactions to guide market pricing, he said. "That's a legitimate reason," Mr. Chen added.

But in conversations across the industry, Mr. Chen said that other managers are realizing they will also have to take similar steps and meaningfully mark down some of their portfolios. That is the case even though appraisal process produces a lag in cases of market stress and a high degree of uncertainty like the industry is experiencing today, Mr. Chen said.

"It leads to a lot of dispersion," Mr. Chen added.