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Wise Words—The Outsourced Blog

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Outsourced Blog:  Randy on the Issues

June 29, 2021. Moss Moskowitz.

Our firm has embraced Monte Carlo risk analysis. What advice can you give us as we embark
on this new course?

Be careful when you think about risk. One of the achievements of the Capital Asset Pricing
Model (CAPM) was recognizing that the risk of an asset was not how the asset performed in
isolation but how that asset moved in relation to other assets within a portfolio and the overall
market. Before CAPM, risk was considered the asset’s own volatility. Advanced risk analysis of
individual assets is usually better than the standard deterministic analysis. However, an asset
whose standalone performance is very volatile may actually reduce overall portfolio volatility
without sacrificing return is the correlation between the asset and the portfolio is low. Risk is
not a characteristic of a single asset. The practice of real estate seems to ignore this important

June 29, 2021. Deon Diogenes.

We are managing a multi-asset portfolio that includes stocks, bonds, private equity, hedge funds, and real estate. How should we deal with returns?

The private equity, hedge funds, and real estate are alternative assets and are more illiquid than publicly traded stocks and bonds. Illiquidity, which creates a performance reporting challenge, is associated with infrequent trading and low turnover, which raises questions regarding the quality of information or price discovery. Reported illiquid assets returns are not returns as we think of them with stocks. Illiquid asset returns tend to overstate expected returns and understate risk due to survival bias, infrequent sampling, and selection bias. Hence, investors should be cautious. Reported illiquid asset returns are not true returns. We need not throw up our hands in abject despair; there are quantitative methods that can help correct these biases, especially regarding property returns, which are notoriously smoothed or serially correlated.

RCZ - September 6, 2022

Risk, governance, and conflicts of Interest

Rounding up the usual suspects at the exclusion of considerations regarding risk often reinforces pre-ordained conclusions, leaves value on the table, and causes owners to assume unanticipated risks. Why does the industry gloss over risk? The buyers, many of whom are institutional money managers, feel pressure to increase assets under new management (AUM). For them. risk may seem distant and speculative. Sellers who seek to maximize net proceeds are even less interested in risk: they regard hard-nosed risk assessment to be a distraction and even a threat. Institutional owners with significant AUM who are engaged in raising capital may hesitate to downgrade any of their existing assets for fear that doing so will undermine capital placement. Investors always chase yesterday's performance. The consultants lack the mandate, the incentive, and even the technical knowledge to adapt risk metrics to real estate. When will this state of affairs change? The office sector, of all the major property sector, cries out for a fresh look at office property risk, especially with regard to property quality and obsolescence. Those managers without negative legacy issues who embrace risk metrics will have a competitive advantage. What is at stake? I believe that the office property sector today is misplaced. Owners should consider selling and putative buyers should exercise caution. A significant repricing of office property is likely but the speed of recognition requires more than the usual suspects.

June 29, 2021. Robby Roberts.

I am a money manager to a large, underfunded public pension fund. Does underfunding affect asset allocation?

Yes, it does. The data indicate that underfunded public pension funds compared with corporate pension funds confer a significantly higher allocation to alternative investments, which include private equity, hedge funds, and property. These assets are illiquid; risk is opaque and the performance reveals itself years after the initial investment. The underfunded pension fund has three unpalatable options: (1) Raise taxes; (2) cut benefits to retirees; or (3) assume additional risk. The first two are politically unpalatable; the third is attractive because the term of a politician’s job (before any promotions) is less than the duration of the investment. These retirement systems are more likely to invest in value add and opportunistic investments. Many pension funds have adopted this strategy in the belief that failing conventionally beats succeeding unconventionally.

June 29, 2021. Neu Olden.

Are the standard asset categories a good way with which to organize a real estate portfolio?

The usual asset categories—office, warehouse, apartment, industrial, hotel—are blunt
instruments. Some analysts address this criticism by creating property type-regional pairs. This
is still too blunt. Slicing geography even finer, analysts look at property-MSA pairs. At this
point, insufficient data become a problem. An alternative way to think about real estate it to
focus on factors which drive risk premiums. Multi-tenanted properties, in particular, are
bundles of factors. Investors seek risk premiums in exchange for exposure to these underlying
factor risks. CAPM is an example of a single factor driving all asset returns. In practice, there
are multiple factors. Why is this important? Investors seek diversification, and the wrong
categories often lead to naïve diversification wherein the investor assumes unexamined risks.

June 29, 2021. Bob Drake.

Do gateway cities provide more liquidity than other cities?

Liquidity, as measured by the rate of turnover of the property market, is not a function of MSA size. Gateway cities provide no liquidity advantage, have higher price volatility, and deliver over the long-haul lower risk-adjusted returns. New supply is less price elastic, which accentuates the effects of short-term demand volatility. Cap rates are higher in many non-gateway cities because AUM growth-hungry investors just prefer larger cities, even at the expense of leaving value on the table. Liquidity (and diversification) benefits vanish during a Crash. Diversification is nowhere to be found when needed the most.

June 29, 2021. Susan Smyth.

We learned in our real estate course that real estate that the essence of real estate is just location, location, location. Is that true?

Simplification can be a help but excessive simplification—crude reductionism—can mask important distinctions and lead investors astray. Location is important because properties, unlike cruise liners and planes, are fixed in space. Fixity has many profound implications. However, there are many other considerations that shape performance, not just location.

June 29, 2021. Francois Rabelais.

Why isn’t tenanted real estate a good inflation hedge. We have been taught that it is.

One of many reasons that tenanted property is a bad inflation hedge is that multi-tenanted property is a hybrid asset that includes bond-like components, called leases, and equity, which behaves like a call option. The value of an option increases with volatility. In addition, leases and other components contain real options, the value of which responds to market volatility, often in complex ways. Depending on the kind of inflation—cost push or demand pull—the value of the leases and the options may not move in the same direction. They can be mutually offsetting or reinforcing.

RCZ - April 27,2022

Pension Fund Pathologies

Professor Timothy Riddiough, who is Professor at the University of Wisconsin—Madison and member of the Outsourced Research Advisory Board, wrote an important paper: Pension Funds and Private Equity Real Estate: History, Performance, Pathologies, Risks”

Here are some important conclusions excerpted from this paper and my own experience advising over 100 retirement systems:

Investment strategies shifted to more opaque, private equity, especially in real estate, with increasing underfunding of pension fund liabilities. Unfortunately, these funds have not delivered the value add and opportunistic targeted returns. Both investment styles risk-adjusted underperformed by 3% per year.
Riskier private real estate investments hinder price discovery and hides true asset volatility. I have shown that property returns are smoothed due to appraisal-based valuations, thus underestimating volatility and risk. Furthermore, investors are not compensated for illiquidity risk.

These underfunded plans are assuming greater risk and achieving performance less than they would were they to leverage core funds.

Institutions favor gateway cities which are especially vulnerable to negative asset pricing shocks.
Pension plan sponsors exhibit “pathological behavior” according to Professor Riddiough. They suffer from herding, display loss aversion, fail to exploit valuable investment platforms, and seek our riskier investments—a call option—to mitigate the underfunding problem.

Plans focus too much on absolute return and not enough on risk-adjusted return. The overall process of institutional investing is flawed due to principal-agent problems that include the investment committees, the pension staff including the CIO, the pension consultants, and the managers who invest the capital. Manager research is especially flawed as it takes instruction from the capital placement and marketing departments.

In other words, institutional investors take the pension plan to the casino.
The likely victims are state and municipal taxpayers.

RCZ - April 14,2022

What are some of the pitfalls and concerns with regard to bidding on properties in a volatile market?

What are some of the pitfalls and concerns with regard to bidding on properties in a volatile market?
Winner’s curse dialogue: “Congratulations, you won the deal. Too bad! You won the deal.” The market continues to heat up. Here is some advice for aggressive managers seeking to increase AUM . . .fast. Bidders make systematic errors due to greater market uncertainty and a large field of competing bidders. The way to avoid the winner’s curse is to reduce a bid to some estimated value fraction, the optimal value of which declines with market volatility and the number of bidders. Unfortunately, by reducing a bid, the anxious investor decreases the likelihood of winning auctions. Investors may decide not to bid at all, which is a choice that over the last two years has resulted in historically low transactions volume, extensive layoffs across all economic sectors as sellers and buyers have retreated to the sidelines. Alternatively, the investor may succeed is exploiting certain informational or first mover advantages, thereby changing the odds favorably.

Controlled laboratory experiments as well as casual empiricism confirm that auction participants fail to adapt their bidding strategy according to competitive models; their behavior is suboptimal. This failure is systematic and seemingly continual, as if there were no learning process. We ask, do market participants have the incentive and ability to adjust their behavior to informational complexities? If pricing is the outcome of a flawed bidding process, what can we make of appraisals and comparable sales data, especially when transactions volume is low?

It is clearly an empirical question whether or not the winner’s curse dominates. We believe that the winner’s curse is a real risk today, especially in real estate markets whose chief characteristic is hidden, asymmetric information.

June 29, 2021. Billy Bogart.

What is the best performance measure, the IRR or the NPV?

Both have limitations, but the IRR, which is the most widely used measure, is the worse. The IRR is misleading. The NPV rule says that the investor should rank all investments in descending order of the NPV. Assuming that the investments are independent, the NPV works. However, if there is a budget or any other constraint, then the investments are not independent. The NPV rule can fail; including the highest NPV project may not be optimal. Development projects are replete with constraints, most of which violate the independence assumption. Introduction of uncertainty with side constraints complicates matters even more.

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