With a desire to both quantify and limit various aspects of private real estate funds’ risk, funds’ documentation is written so that risk is unbundled and limited. Examples of this would be using “up to 60% leverage”, “up to 50% development exposure”, “up to 50% vacancy”, etc.. This feels like good practice as it implies that investment managers become risk managers deciding how, when and where (not) to place risk.

Managers then have the capacity to take on “up to” that limit, but they do not always have to utilise the full capacity. The issue here is that the limits can be used as targets; just as the speed limit for a car is often used as a target.

If fund managers were acting as risk managers we might expect to see them managing their funds’ risk capacity, perhaps lowering risk before markets fall and taking on more risk before markets begin to recover. Now, if that were the case, funds that have the capacity to take on more risk would perform similarly to the lowest risk capacity funds during a downturn and far ahead of them during an upturn. This is because, funds with the capacity to take on more risk “up to” a certain level have preserved the ability to take on much less risk than the maximum permitted under their documentation and, potentially, to mirror lower risk capacity funds.

In theory then, higher risk capacity funds ought not underperform lower risk capacity funds in a downturn since high risk funds can de-risk to levels equivalent to low risk funds by using their legally-preserved ability to go “up to” a certain risk parameter.

In practice, this does not appear to be the case.

The data would suggest that, on average, high risk capacity funds tend to underperform low risk capacity funds when markets fall. This was highly visible during the GFC and appears to be emerging again now. It is not necessary to predict a specific downturn to gauge that risk might be expensive and to realise that, if a downturn comes, then risk will become much less expensive, or even cheap, as prices for the most risky strategies fall.

This underperformance could be down to a number of reasons such as:

1. a failure to realise that risk was expensive

2. a failure to act when correctly realising risk was expensive

3. “inability” to act; prior actions have “removed” optionality - though it is likely that an unpalatable choice does remain, or

4. differentially high fees for higher risk-capacity funds.

Another reason could be that moving to a lower risk position, when other funds are not, means taking on an “uncomfortably idiosyncratic” position. Failing conventionally is a potentially powerful motivator of inaction since failing unconventionally is usually tied to career risk. That is, you might actively choose not to act, despite your concerns, finding comfort instead by being in the crowd and seeking out confirmation of an alternative rationale behind this inaction, only later to deploy the “nobody else saw it coming either” narrative if things go wrong.

Whatever the reason, the capacity to take on more risk does not equate to a requirement to take on more risk just as a speed limit does not require you to target that speed limit but to stay below it, adjusting your speed depending upon anticipated conditions and even coming to a complete stop if it is not safe to proceed.

Nonetheless, investors tend to ask fund managers what levels of risk exposures (leverage, number of assets, locations of assets, types of assets, vacancy, development exposure, etc.) funds are targeting. This might imply that, regardless of market circumstances, investors are looking for managers to manage risks to a certain level, a target, in the full knowledge that utilising a high risk capacity at all times may well result in underperformance if and when markets turn down. Were this to be the case, investors would not be looking for fund managers to use their skill to manage risk to deliver improved risk-adjusted performance but to target a strategy which is like driving at a constant speed regardless of the traffic on the road. For higher risk capacity funds, this is destined for intermittent failure but might be a thrilling ride in the meantime.

By ensuring that managers manage funds to a certain level of target risk, it does make it easier to bucket fund strategies into styles such as core, value-add and opportunistic that fit neatly in a spreadsheet, but it might be smarter to allow managers to use the full range of options at their disposal and to prove their skill, or otherwise.