Distorted Real Estate Time-Weighted Rates of Return - And How Having Carried Interest Can Make It Easier to Outperform ODCE

Abstract

NCREIF/PREA Reporting Standards for computing gross and net time weighted rates of returns (TWRs) are flawed in two respects, thereby producing distorted results for both real estate managers, as well as for the fund-level industry indices against which the managers’ performance may be compared. The far less frequent, yet potentially far more serious flaw impacts only investment entities, as well as the industry indices, which have accrued incentive fees or carried interest.The introduction of the flaws seems to have emanated from a loss of industry perspective, where real estate TWRs came to be regarded as indicators of investor performance. However, as detailed herein, TWRs were created for the express purpose of comparing the performance of managers. Before fee TWRs help to assess a manager’s ‘pure skill’. After fee TWRs help to assess the manager’s ‘cost-adjusted skill’, meaning the manager’s pure skill adjusted for the cost it took to avail oneself of that skill. Both types of TWR can be important, depending upon what insight an investor wants to glean. The flaws identified herein are subtle and, to be fair, remain somewhat controversial to those who have not fully embraced the fact that the primary role of TWRs is one of measuring comparative manager skill. For those reasons, drafts of this article have been circulated among TWR experts and aficionados, both inside and outside of real estate, seeking critical feedback, with the vast majority of experts consulted agreeing that the flaws are both real and potentially serious. The flaws, in principle, are extremely easy to fix. However, in practice, fixes can be time consuming and costly and, as a result, resistance to change from various parties should be anticipated. The alternative to never changing is to knowingly continue to perpetuate these flaws both in existing managed investments and index products, something that unfortunately will, for understandable reasons of consistency, surely cause the flaws to be introduced into all subsequently created investments and fund level indices as well. No doubt, some investors don’t take producing accurate TWRs that seriously, believing that they are little more than mere numbers on a piece of paper, numbers that don‘t impact or reflect ‘true economics’. However, even if, indeed, they do not use TWRs to make decisions on hiring or firing managers, it should be noted that TWRs may impact their incentive fee payments. Specifically, as more real estate indices have been created, more real estate incentive fee structures seem to be incorporating a TWR-based performance test of some form or another. If the TWR test fails, meaning that the manager has underperformed relative to some pertinent index, then some contracts then dictate that the incentive fee payment is to be reduced, if not eliminated entirely. As such, this TWR problem is not limited to mere “performance reporting” distortion, but can also result in sizable errors in the amount of incentive fees actually paid to managers by their investors.