The churning year 2000 stock market may lead institutional money managers to consider this year's annual review as an opportunity to begin re-balancing portfolios thrown out of kilter by years of substantial stock market gains.

According to institutional portfolio advisors, a pension fund or life insurance company might typically devote 60% of its funds to stocks, 30% to bonds, and 6% to 10% to real estate, depending, of course, upon investment goals. In addition, a cash allocation of approximately 5% might skim a point or so from each of the other major categories.

In re-balancing portfolios, managers may decide to reduce stock allocations swollen by the market's run-up, and real estate may benefit from the process.

"Instead of being at 60%, institutional stock allocations are closer to 70% today," says Andy Smith, COO of L&B Realty Advisors Inc. of Dallas, a pension fund advisor serving public, corporate, and eleemosynary organizations. "Over the past few months, institutions have begun to move down their appreciated stock allocations, giving serious consideration to real estate, which remains a reasonable value and has not become overpriced."

Larry Vogler, executive managing director for the Chicago-based HIGroup, an agent of and consultant to institutional investors, has sensed a trend in this direction as well.

"The run-up in stock prices has increased the value of their assets so much that they are under-represented in real estate. In addition, many have come to believe that the stock play may be behind us. These are reasons to look at real estate opportunities."

Although institutional investors may be persuaded to re-balance their allocations to place a greater emphasis on real estate, they still face a dilemma: Do they invest in commercial office, retail, industrial, hospitality or residential? The answer depends on the role defined for real estate in a portfolio and the level of risk that institutional investors will take.

Institutional strategies Real estate investment strategies can be separated into three categories: core, value-added, and opportunistic and range across all levels of return.

Institutional advisors define core investments as safe, stabilized properties with few competitive worries. These properties come at high prices with limited upside potential, but generally produce steady income over a period of years.

A value-added real estate strategy, sometimes referred to as core-plus, generally requires direct equity participation and operational expertise.

Properties offering value-added potential are available at a discount based on problems with tenant mix. By renovating and repositioning, the investor creates a stable cash flow that allows the property to appreciate; hence the terms "value-added" and "core-plus."

Opportunistic investors identify capital-starved areas of the country or categories of real estate and pursue direct investments, contingent on the execution of specific tasks. Exit strategies call for a sale as soon as the planned tasks produce the anticipated return.

Allowing for variations in individual approach, most advisors set return goals of around 10% for core investments, 12% to 17% for value-added investments, and 20% and up for opportunistic investments.

Gyrations in the marketplace Depending on the market, particular real estate investments might fall into different strategic categories at different times. Take REITs, for example.

"Five years ago, REIT stocks soared because the property markets were not in equilibrium," says John Taylor, senior managing director of alternative assets for Banc One Investment Advisors in Columbus, Ohio. "It was relatively easy to acquire direct investments in real estate at substantial discounts. REITs did this. As the markets came back, investors earned returns in appreciation and cash. For a couple of years, REITs provided 20% total returns. That's great for real estate."

By the late-1990s, real estate valuations had regained their equilibrium and REIT stock appreciation halted, leaving investors with more typical dividend returns. Investors with higher goals sold REIT stocks, which, by the middle of 1999, often traded as low as 20% below net asset values.

While this year's stock market upheaval has helped REIT stocks to recover somewhat, few analysts expect the category to deliver significant appreciation going forward. Once an opportunistic investment, REIT stocks now serve core strategies.

All three strategies - core, value-added and opportunistic - remain in play today, although most institutional advisors are recommending moves down the risk scale toward core investments perceived to be safe.

"It's more of a core market today than a few years ago," confirms Ray D'Ardenne, COO of Atlanta-based Lend Lease Real Estate Investments Inc.

"We expect real estate to play a role in stabilizing portfolios for our clients," adds Taylor of Banc One. "That means more income than growth. Our expectation from a fundamental real estate side would be returns somewhere between 7% and 13%, with 60% of that return coming in the form of current cash flow, including dividends from REITs."

Property categories and risks Advisors generally agree that core real estate investments today include office buildings in the CBDs of 24-hour cities such as Boston, Chicago, New York, San Francisco and Seattle. On occasion, investors will encounter an opportunistic deal in one of these areas. For example, Lend Lease manages interests in existing core office as well as opportunistic office development in this market, according to D'Ardenne,

"We're involved in the development of a building in downtown Chicago at One North Wacker," he says. "This is one of Chicago's best sub-markets, and it has phenomenal assets. The site was tied up for years by different owners, who never built because market supply was great. But clearly this was the next site to build. We bought it, and we're building."

D'Ardenne recommends investors proceed cautiously when evaluating office space in cities and in the suburbs that thrive almost exclusively from 9 a.m. to 5 p.m. Office building prices in these cities probably won't appreciate beyond caps set by office buildings in the suburbs.

Furthermore, these cities and their suburban counterparts contain available space where competitive office buildings might rise in the future, adversely affecting the asset value. "I would be a net seller in these kinds of areas," says D'Ardenne.

Core real estate also includes multifamily developments. Lend Lease advisors like the core returns available in the apartment business, a sector long considered a weak area for the company. The recent acquisition of Boston Financial by Lend Lease promises to change that. "Boston Financial owns and specializes in multifamily properties," D'Ardenne says. "The company is also the dominant provider in the investment tax-credit business in low- and moderate-income housing."

L&B Realty's Smith agrees, noting that cash flow generated by apartments can dampen the volatility of other real estate investments. "In an office building, for example, tenants have longer leases, and the tenants move in and out," he says. "Cash returns might run to 8% one year, fall to 6% the next, and go back up to 9% in the third year. Apartments sit there and generate 9% or 10% year after year and smooth out the ride of other investments."

Industrial real estate, specifically distribution facilities, represents another core investment in today's market. "The industrial category has always been a real estate cash cow," declares D'Ardenne. "This market does not get as overbuilt as other categories. In addition, the capital expenditures are lower. Tenants go in with limited office build-out and finish requirements. So the fundamentals of the income stream are not as cyclical as other categories."

Favored industrial real estate today includes state-of-the-art distribution facilities, continues D'Ardenne. Such facilities feature ceiling heights in excess of 30 feet, virtually flat floors to allow high stacking, advanced technology equipment, excellent truck courts and staging areas, and solid access to transportation hubs. "In this area, I would be careful about low ceilings and inferior transportation facilities," advises D'Ardenne.

Most advisors place retail real estate higher on the risk curve, with the exception of established top-tier regional malls. Few of those, of course, are for sale in today's market.

"Retail can be a quagmire," says L&B's Smith. "Returns have improved over three years ago when people were concerned that there was too much retail. We're still concerned about that today, although there are attractive investments in the right kind of retail, such as grocery-anchored centers located in affluent neighborhoods."

E-commerce has also created uncertainty about the brick-and-mortar retail market. The experience of the 1999 holiday season allayed some of these concerns as the dot.coms demonstrated uneven service abilities. The consensus today is that brick-and-mortar retail will prosper side by side with e-commerce with the possible exception of power center stores selling commodity goods.

By far, observers rank hospitality and single-family housing developments among today's riskiest property types.

Selecting strategies Institutions base strategies upon the underlying return requirements of the assets they manage. A pension fund supporting many retirees, for example, might favor a core strategy designed to defend against capital depreciation and to produce current returns. A smaller, younger pension fund may seek higher value-added and opportunistic returns.

A large pension fund may allocate its real estate holdings across the return spectrum. As a result, advisory firms have devised strategies around goals ranging from income to high growth.

AEW Capital Management, a Boston-based advisor with $6 billion in net assets under management, offers strategies across this spectrum, according to Jeff Furber, the firm's managing partner.

"We work in three areas," Furber explains. "The first is core and core-plus (or value-added) investing. Here the return targets are 10% to 15%. A core investment might go into a fully leased, Class-A building. You buy it for yield, not the upside. Core-plus investments would buy the same kind of property, with the intention of repositioning and renovating. You would assume more risk and look for a higher return."

Second, AEW Capital Management also offers private equity investments in opportunistic funds seeking returns of 20% and higher.

Third, the company advises clients about securities such as CMBS and REITs.

Other companies have created even more segmented strategic options. L&B Realty Advisors offers clients 12 options aimed at office, industrial, multifamily and retail properties. "These strategies are like a menu," says Smith. "When you can choose from 12 individual strategies across all four of these property types, you can build strategies for individual portfolios.

"There are two kinds of investors - those who want the money now and those who will wait to get a gain at the end of the day," continues Smith. "Our strategic menu enables our clients to play the game differently, according to what they want to accomplish and the risks they are willing to take."

Smith believes that opportunities exist in the real estate market at both ends of the strategic spectrum. If an investor pursues a core strategy, with low risk and a good cash return, such a product can be found in any of the four property types, he says. " If you want more appreciation, you might find it in office and retail today. It's possible, but difficult to find these kinds of returns in the multifamily and industrial categories because those properties are in great demand, and the price to get in is high," he adds.

Steve Smith, managing director of global client services for Chicago-based LaSalle Investment Management Inc., agrees, noting that LaSalle's newest fund focuses on value-added real estate investment.

"Value-added means taking a little more risk, putting moderate leverage on a portfolio and aiming for returns in the range of 13% to 16%. In other words, investors will expect a couple hundred basis points for positive leverage," says Steve Smith of LaSalle.

"But investors must also work to get those extra points," he continues. "You might buy a building with leasing problems and go in with your leasing people. In other words, you add something from an operating perspective. Returns involve operating issues rather than pure capital. That's the value-added game."

Sizing up opportunities While many institutional investors have scaled back their return targets for real estate, some, especially smaller pension funds, continue to focus on opportunistic investments.

Legg Mason Real Estate Service Inc. in Philadelphia advises pension funds, life insurance companies and high-net-worth individuals interested in returns in the value-added and opportunistic range. The company, which is owned by Legg Mason Inc., manages approximately $1.8 billion in real estate assets, including unfunded commitments. These assets include whole mortgages and direct equity in commercial real estate.

According to Richard Layman, managing director of equity real estate for the firm, Legg Mason pursues its strategies by targeting investment structures and property with upside opportunities.

For example, a Legg Mason fund called Eastern Retail Holdings focuses on grocery-anchored neighborhood shopping centers. Generally more of a core investment, certain neighborhood centers represent repositioning opportunities.

"We look for owners who are disinterested or don't want to put in the capital to address a repositioning need," says Layman. For example, Legg Mason has purchased centers with obsolete 30,000 sq. ft. grocery store formats and found ways to backfill to create a 50,000 sq. ft. space, large enough to accommodate a new grocery format. "This is the kind of situation where you add value," says Layman.

Legg Mason also pursues incentive-development or merchant-build agreements with small developers. These complex structures may add 100 or more basis points to a yield and move the deal up into a return range acceptable to Legg Mason clients.

Layman contends that today's market continues to offer opportunistic returns to those who know where to find them. By way of example, Layman points to Legg Mason efforts in both hospitality and residential land development.

"One hospitality strategy we have done involved putting together a local development company in the Philadelphia area," he says. "This company had extensive experience in the hotel business, on both the financial and development sides. Over the past two years, this company has completed five limited-service hotels, all under the Marriott and Hampton Inn names."

In the residential area, Layman looks for opportunities to build and sell apartments, earning upside returns upon the sale. "Buying multifamily properties at an 8% cap rate doesn't fit our clients' goals," Layman says.

"So we want to develop, not buy, these properties. One project we have involves a private REIT and a development site in Virginia. The REIT is building on property zoned for multifamily use and located next to land zoned for single-family homes being developed by a national home builder," explains Layman.

Layman generally pursues a contrarian investing strategy that strays far from the focus of core investing. In the commercial office category, for example, Legg Mason has avoided sought-after CBDs and 24-hour cities, while pursuing opportunities in suburban and in-fill markets.

"In two cases, we have acquired owner-occupied buildings where the owner wanted to reposition by downsizing," says Layman. "We renovated those buildings and covered our downside with the anchor tenant, who in these cases was the seller," says Layman.

"The point is that we are driven by a higher total return target. There are clearly fewer opportunities for this today, and you have to be more aggressive in terms of time and effort to find them. But the real estate universe is huge, and the opportunities are there," adds Layman.

Can large and small funds alike find opportunistic returns in today's market? Layman concedes that large pension funds with $10 billion allocated to real estate may have difficulty finding as many opportunistic investments as a pension fund with $1 billion or less allocated to real estate.

Overall, the institutional investment community appears to have tilted to the core and core-plus side of real estate in the current maturing market. This emphasis contrasts sharply with the speculative excess characteristic of the last mature market - in the late 1980s and early 1990s - which led to collapse.