Real estate funds that favor a riskier approach are more likely to have leverage determine their underperformance, as shown by a recent study published by the Urban Land Institute (ULI). To reach its conclusions, the study employed a model which measured leverage impact on underperformance for 169 core, value-added and opportunistic funds.
In their analysis, Reading University professor Andrew Baum and his team discovered that opportunistic funds performed worst of the three styles on a risk-adjusted basis from 2001 to 2011. An opportunistic fund that is 60% leveraged is expected to report annual underperformances of up to 13.2%.
This research supports findings of prior UK market studies and showed that leverage was much had a more important role to play in poor performance than property selection. It also showed that fund managers' choice of properties has less impact on performance than it was previously believed. When factoring in leverage, the decisions on property risk exposures became statistically insignificant.
Adding asset-level value did not impact the results much, as each 10% of leverage in value-added funds reduced annual returns in value-added funds by 2%.
"The impact of leverage – especially in the 2008-09 period – was so punitive that the return delivered by any good work being done by managers was likely to have been obliterated," the report concluded. The fault for using excessive leverage is not only of fund managers, as investors likewise "appeared willing to invest large amounts of capital in the strategies".
Although the report chose not to include external factors in their analysis, ULI acknowledged the style-specific contribution of fund vintage, management and market factors in assessing fund underperformance.
In the case of core funds, where leverage was only partially responsible for poor results, underperformance in the three years to 2011 could be attributed to pressure on open-ended funds to deploy accumulated capital in overpriced prime.