Given the present state of the commercial real estate markets, what is on the minds of top institutional investors and advisers who deal in the market every day? To help us answer that question, Insignia/ESG and NREI partnered on a recent roundtable discussion held at the Ritz-Carl-ton/Buckhead in Atlanta. The discussion was co-moderated by Robert Cohen, executive managing director for the Mid-Atlantic region of Insignia/ ESG in Washington, D.C., and Ben Johnson, NREI's editorial director.

Robert Cohen: Investment strategies have changed a lot over the past seven years. The analysis was you would buy real estate and there would be a 10-year IRR and a disposition. Then that slipped to seven (years) and now it's slipping to five and three and maybe it's even shorter in some cases. In your view, what is driving this change? Is it the investors, the advisers, the market conditions?

Bill Scully: The 7-year timeframe is interesting, particularly sitting next to Seth, who I used to work with at GE seven years ago.

If you go back further, a lot of people got locked up in vehicles where the manager of the vehicle had no incentive to ever sell. I hear people talking about having sell discipline, but it's all nonsense. You had an incentive to continue to manage assets and own those assets for a long time. And if that's what your investors wanted that was fine. There was a confluence of interests there, but in a lot of cases the manager really if they had their own money invested, would have said this is as good as it gets, it's time to exit.

Which is why you've seen the migration into what we're doing today. We're investing our own money and we're telling our investors when it's time to sell, whether it's six months or five years. We have proper motivation to sell. I think there are asset classes in the real estate business and there is a place in the place where we don't play in, the core investments, that just doesn't work for people like us who want to be interim investors and move in and out of property types. It's a reaction to a bad experience in the '80s when too many people felt like they got trapped. The small guys got trapped in publicly traded limited partnerships. The general partner had no incentive to liquidate for the benefit of those investors. If you go back seven years, we were all buying busted debt with an 18-month investment cycle. We kind of have a five-year investment philosophy today.

Seth Lieberman: We have a slightly different investment focus, where we look for product in a slightly different niche in the marketplace, because, candidly, we don't want to be competing against the other funds because that makes the markets a bit more efficient and potentially drives down our returns. But we tend to look for transitional situations.

Clearly there are a large amount of funds put into the market by institutional investors looking for core-plus, longer term returns. But the same investors have realized there are transitional situations where management will have an alignment of interest and management will seek to optimize returns on their behalf. When you're dealing with transitional situations and you're trying to optimize returns, when something's fixed, whether that's 18 months, two years or three years, that's clearly the best time to sell the asset.

So we tend to look for opportunities that are five years in nature, with business plans that can be executed in a two- to four-year period, albeit my sense is, as markets get a little bit flatter now, that the value-add may take a little bit longer. And you won't have quite as quick trades nowadays because markets may not be moving up as quickly as they were.

We're a little bit of extra spice to the institutional investor community and we give them some liquidity because of the alignment of interests.

Bruce Fernald: Cornerstone was established five years ago on the premise that we would deliver to our customers top returns as measured against NCREIF. What that enabled us to do, largely in the first three or four years, was to ride the recovery of the office sector up. In parallel with that recovery and those handsome returns, we assembled a group of hotel professionals who convinced us that although hotels are an operating business, a business that requires a specific expertise, we were able to put together a team that bridged both the operational side and the investment side.

So as we look toward preserving and building on this track record of relatively high yields, hotels continue to offer that opportunity. Secondarily this philosophy drove us into multifamily development, which we see as relatively more straightforward to underwrite than the development issues you face in the office sector.

Arthur Segel: I agree with what's been said, but also the whole securitization of the industry in the past few years forced everyone into short-term investment time horizons because we just couldn't show returns to compete with the REITs.

Now the tables have turned. I would argue that we are going back to the early-'80s, where the public funds, which are still pouring a tremendous amount of money into this industry, are pretty much buying, as they were in the early-'80s, the fixed-income security with an equity kicker. For that reason, and there are no great runups in real estate prices, for that reason it will be more of a long-term hold, what they used to call the European model where you own for a long period of time and there isn't that much turning anymore. There will be the specialty opportunity funds, the value-add niches and so on, but by and large, I think we're going full circle to where we were.

Don Miller: A lot of this is being driven by what the clients are looking for. So many of the pension funds in the 1980s were looking at putting money out into real estate as an asset class for all the traditional reasons - an inflation hedge, lack of correlation to their other asset classes, etc. - but what's happened in the 1990s is that so many of them have turned around and said, 'I'm not in real estate for those reasons anymore, I'm in real estate because it's a return enhancer and if I don't believe it's a return enhancer, I'm not staying.'

So they're going into the investment class looking for returns that are at least equal or superior to the equity market returns, and you don't get those returns if you're on a 10- or 15-year hold basis in real estate. They just aren't there.

Ben Johnson: Are they also telling you to turn, to sell?

Miller: Absolutely. One of the requirements for the fund I've been out marketing is to have a really well formulated exit strategy, not just for the fund but for every individual asset. They're going to expect you to be able to tell them about when you're going to be able to sell that asset at the time you buy it. If it's more than four or five years out and your investment horizon is five years, they're going to be wondering why you aren't executing the strategies.

Victoria Kahn: You highlight a dichotomy, at least from my perspective, representing pension funds. Yes, absolutely today they are very return-driven, no question about it. But that being said, they still are focused on this 10-year valuation model.

Despite reasoned, logical recommendations to sell, they are very reluctant to sell early, and early to a pension fund is in this three- to five-year cycle. Five to 10 years is a longer term and a more traditional sell opportunity for pension funds. I find that to be a continuing issue. Pension funds by nature are a little slower to react, there is always a little bit of catch-up time, and I think we will see them change going forward, but I don't think they are in full implementation yet.

Jim McWalters: We're pretty traditional in that way, too. We deal with 10 separate accounts. They're all public plans, they all have underfunded situations, they're all putting out new capital, and most of them are discretionary. Those that aren't discretionary, I can't remember a situation when they've overridden a recommendation we made. We pretty much get to do what we think is right.

My observation is similar to the rest of the panel. The reality of the holding period for us is shorter than the perception. While we analyze on a 10-year basis, many of our clients measure us on a one-, three- and five-year basis against a peer group, as well as against NCREIF. The practical part of that is from our perspective, if we don't produce those comparative performance numbers we get terminated. That hasn't happened yet in our industry, but it's a risk.

We recently analyzed our own activity. On one client we've been with since 1986, we have turned over 40% of that portfolio since we began investing for them. The other one we've been investing with since 1993, and we have turned over almost 40% of that portfolio. So the average holding period is something less than seven years for us. This is in a core account where there is no mandate to hold or to sell.

It's driven by two things - we get an offer which exceeds our forecast expectation if we were to hold. The second was that our own expectation going forward of how we thought our investments would do didn't meet our reasoning. As we looked at each investment going forward for the next 10-year period, we're better off to pay the transaction cost to get out and reinvest rather than hold this particular investment, given the risk scenario we see from an economic point of view. The practicality is the holding periods have shortened.

David Pahl: I come from the perspective of German capital, which is traditionally very long term. We represent a number of different types of funds, both open-end and closed-end funds, which are very much long term. We do proformas on deals that are 15 and sometimes 20 years in length.

We also represent a number of German institutions on a private fund, where we can be much more proactively managing it, looking at maximizing value and selling properties here and there. We will typically look at deals long term even in that group, but with the idea that would need to have the liquidity potentially to sell if we need to.

Johnson: Have you had to educate them about new time horizons?

Pahl: Yes. There's been a bit of that. But they come from such a different mentality than here. Real estate is such a core investment. In Germany you just never sell. Institutions know and understand they have to have the flexibility and liquidity to take advantage of markets when they can.

Kahn: Just re-read your European history and you'll know why real estate is so terribly important.

I have seen in the last 12 months an increase in allocations among pension funds for real estate, and by significant measures.

Fernald: Is that because with the run-up in the stock market, the pie is larger and therefore more dollars need to go into real estate?

Kahn: The average is about 5% for the larger funds, with a theoretical cap of 10%. And we're seeing it move from 5% to something significantly higher than 5%. Some of our clients have increased it to 9%, which is a very large amount in terms of pure dollars.

Scully: Why do you think that's happening?

Kahn: A number of things - the general expansion of the economy, the realizaton of much higher returns. This lag in their investment models that I spoke about earlier. It's interesting now that as opportunities start to tighten and you see cap rates start to climb a little bit, and the availability of capital, they may be a little bhind the curve there. We all probably wish they had increased their allocations about 24 months ago, but we're still happy to see it.

Fernald: Are your clients concerned that there is too much money chasing buildings, or that the allocations are going up too quickly as the market's flattening out?

Kahn: You could say that of everything. There is too much money chasing dot-com stocks, in theory, but there is an investment opportunity.

Scully: But is that driving a lot of your clients who are looking at the equity markets are so frothy that they feel better about the downside risk?

Kahn: Absolutely.

Scully: That's why the public-REIT sector is so moribund, to some extent, because the rest of the equity sector has done so well.

Kahn: There may be another aspect of it, too, and that is the investment structuring has changed, certainly for our clients, over the last few years and the aversion to debt is gone. There is a lot of joint venturing, with private and public partners, which in itself is seen as a risk mitigator. So you're getting in and out of the market differently than you did before and acquiring differently. And in general, I think they understand the asset class better than they did.

Lieberman: They've learned, they've profited and they want to continue.

McWalters: Having recently been in front of boards and talking about this exact subject, in every case where I get the question, 'Given what you see where you are in the cycle, is this the right time for us to be buying?' The answer I give, and with which they are comfortable, is you're not going to get the same internal rates of return buying today as we would have gotten had we bought in 1995 or four years from now as the cycle turns.

But the yields you do get will meet your guidelines. And over the long term, we believe, in up and down cycles, in order not to have to be a market timer - which they've learned from the securities markets is extraordinarily difficult - that they will meet their financial objectives by continuing to invest, perhaps more conservatively today than we did in '95 or '96, but nevertheless continue on with the program. In every case, the boards have all said, 'Fine, keep going.'

Pahl: Does that mean longer holding periods?

McWalters: At least for us, it means a more defensive strategy where we're now more focused on the stability of cash flow over the next five years than we were in '94 and '95. We're looking for a smaller percentage of total return to come from the depreciation component. So if we were going to do a 12% internal rate of return in '95, today maybe we'll do 10.5%, but we might get 80% or 85% of that 10.5% from cash flow.

Kahn: I would agree very much with that.

Bruce Fernald Cornerstone Real Estate Advisers

Victoria W. Kahn Clarion Partners

Seth Lieberman Praedium Funds

Jim McWalters PM Realty Advisors

Don Miller Lend Lease Real Estate Investments

David Pahl TMW Real Estate Management

Arthur Segel TA Associates

Bill Scully Apollo Real Estate Advisors

Robert Cohen (moderator) Insignia/ESG

Ben Johnson (moderator) NREI