It is no secret that institutional investors have been busy rebalancing their commercial real estate portfolios in recent years.

Although investors continue to have a steady appetite for commercial real estate, risk has been less palatable and today’s portfolios clearly reflect that penchant for buying core properties. For example, among pension funds, core assets represent nearly half of total real estate investment allocations, compared to opportunistic at 32 percent and 19 percent for value add, according to an August 2012 Investor Report by the Pension Real Estate Association.

The stable base of core assets coupled with a growing demand for higher yields may cause portfolios to begin tipping more in favor of value-add investments. “I’m seeing some movement in the value add space, because people are trying to achieve some additional yield by taking on additional risk—especially given the low cost of capital,” says Steve Pumper, executive managing director for capital markets at Houston-based Transwestern.

Investors have a better feel for what is going to happen in Europe, what’s happening in Washington in relation to new policies and tax laws, and which cities are showing signs of recovery with proven job growth. As such, investors have more confidence on placing that value-add money to achieve higher yields to maybe offset some of the lower returns that they are generating with some of the core buys. “I think it is a hybrid approach to investment strategies. Investors are playing at both ends of the spectrum,” says Pumper.

Buyers remain selective

The flight to quality and safety remains a driving force. However, in the past six months institutional investors have been more willing to consider value-add acquisitions. Investors are increasing their allocation to real estate, and some of that capital is flowing to higher yield products.

“I would not say that it is a broad, sweeping, tsunami-like trend, but there is definitely more appetite for risk,” says Hugh Macdonnell a managing director at New York City-based Clarion Partners LLC. “We see that manifested by clients asking for higher return products.”

The caveat is that even though investors are interesting in taking on more risk in exchange for greater returns, institutions still remain highly selective when it comes to choosing those assets. “Our approach to value add involves seeking out higher returning assets—through repositioning, releasing and refinancing—within the deepest and best performing markets,” says Macdonnell. “This strategy has produced outsized returns in prior cycles and we expect the same here as well.”

The prime focus continues to be the top seven to 10 core markets, including 24-7 cities, as well as some increased interest in the CBDs of secondary markets and some of the strong suburban markets in those primary markets. The risk that investors are taking on is in the form of well-located buildings that may be under-leased. Institutions are stepping in and trying to acquire office properties, for example, where they can fund capital expenditures and tenant improvements and commissions so the properties can better compete and improve occupancies as markets recover, notes Pumper.

Core assets are top pick

Core will continue to dominate institutional investment strategies. That being said, portfolio allocations may decrease slightly this year, because it is harder to find core properties, Pumper predicts. Sales prices also remain highly competitive for top assets.

For example, Clarion Partners recently purchased 100 Spear Street in the heart of San Francisco. The company acquired the class-A, LEED Gold-certified office tower for $100 million. The purchase price on the 203,259-sq.-ft. building amounted to about $492 per square foot. Clarion paid a premium for the property, which is about 91 percent occupied.

Even for investors that are willing to pay premium pricing, there isn’t enough deal flow to satisfy the equity needs of institutional investors. “There is a dearth of deals available in that core space. So what you are going to find within those funds is that they have to go out and look for ways to place that capital,” adds Pumper.

There are definitely a number of investors who are focused only on core assets and will continue to do so, agrees Macdonnell. Core assets have performed very well through real estate cycles. The returns from investing in high-quality core are 7 to 8 percent, he notes. “That is very attractive, especially relative to alternatives,” he says. “Yet there are those investors who have been investing exclusively in core, who are now looking to broaden their investing framework.”