Institutional portfolios have been increasing allocations to global real estate (RE) core+ debt, often via a private fund investment vehicle. CIOs managing a multi-asset portfolio with allocations to both liquid and illiquid assets need to evaluate the cash flows from each asset class to better understand their portfolio’s liquidity risk. However, due to the specific cash flow pattern of core+ RE debt funds, and a lack of publicly available data, commonly used cash flow models for other private assets such as private equity are not suitable.
We present a new cash flow model for private core+ RE debt funds using reasonable, practitioner-supplied parameter estimates. The model incorporates sensitivity to the economic environment both at fund launch and over the fund’s life. This core+ RE debt cash flow model can be integrated into a multi-asset portfolio analytics tool such as OASIS™, to help CIOs evaluate the diversification and liquidity management potential that private core+ RE debt may bring to their portfolios.
Core+ RE loans typically present more real estate credit risk compared to a core loan which is secured by stabilized properties but generally have less risk than heavy transitional loans that finance a property’s full “transition” from one use to another. RE owners use core+ debt for a limited period while they make property improvements through renovation or repositioning – and afterwards refinance with a long-term, fixed-rate core loan or payoff the debt through a property sale.
Investors are typically attracted to core+ RE debt for its scalability, current income, credit quality, low principal value volatility, reduced interest rate risk via floating rate structures, and portfolio diversification potential. Institutional investors can invest as a limited partner (LP) in either a closed-end or open-end core+ RE debt fund. Figure 1 presents an indicative fund structure which is a portfolio of loans originated at different times and with different terms and spreads negotiated at each loan’s origination.
We take a bottom-up, loan-level approach and then aggregate loan-level cash flows to estimate fund-level cash flows. The model captures four loan-level activities: origination, credit risk changes, extension, and prepayment. (Figure 2)
Figure 3 presents an example of loan-level cash flows of a core+ RE loan. The loan is a 3y loan that originates in a good economy and prepays after 2y. The loan pays a prepay penalty equal to one year of interest.
Figure 4 shows an example of a close-end core+ RE debt fund which launches during a good economy. Capital calls occur quickly as the GP actively invests during the good economy. During the capital return phase the fund experiences 2.5y of a bad economy (shaded region) which significantly reduces distributions due to delinquencies, higher LGD, and a greater number of loans that extend.
As allocations increase, a portfolio’s liquidity structure changes. How can a CIO increase their confidence with private assets and unlock their potential?
In this paper, IAS explores a modification to the TA model in which a series of periodic growth rates are used to model distributions and valuations.
PGIM and the Institute for Private Capital (IPC) joined together for a special research workshop which convened eight academics and practitioners.
