From:~angeeta Bhatia, Retirement Plan Manager

Transcription

1 Date: November 19, 2012 CITY OF LOS ANGELES DEPARTMENT OF WATER AND POWER INTRADEPARTMENTAL CORRESPONDENCE To: Retirement Board Members From:~angeeta Bhatia, Retirement Plan Manager Subject: Board Agenda Item No.7: Report on Prudential Real Estate Investors Due Diligence On-Site Visit (November 28, 2012, Regular Retirement Board Meeting) Investment Officer, Devin Billingsley met with representatives from Prudential Real Estate Investors (PREI) on September 26,2012, in Madison, New Jersey, to review and discuss the organization and real estate funds being managed by PREI on behalf of the Plan. In December 2006, the Retirement Board approved an investment of $50 million in PREI's PRISA fund, an open-end Core real estate investment fund. In June 2007, the Retirement Board approved an investment of $21.5 million in PREI's PRISA II fund, an open-end Core-Plus real estate investment fund. As of June 30, 2012, the market value of the Plan's investment in PRISA was $48.6 million and the fund has generated a since-inception internal rate of return (IRR) of -1.40%. As of the same date, PRISA II's market value was $20.7 million and the fund has generated a since inception IRR of -1.90%. Mr. Billingsley interviewed the personnel directly responsible for managing the Plan's assets and observed and confirmed the capabilities of the management team and the resources available to PREI to manage the funds. He met with: Eric Sabol - Director, PREI Marketing and Client Service Joanna Mulford - Portfolio Manager, PRISA Nicole Stagnaro - Assistant Portfolio Manager, PRISA Jameel Nabulsi - Portfolio Manager, PRISA Darin Bright - Portfolio Manager, PRISA II. Justin Gleason - Vice President, PRISA II Dr. Youguo Liang - Director of Research, PREI Key functional areas discussed were the overview of the company, investment process and risk controls, performance, fund structure and administration, and disaster recovery and business continuity. Company Overview PRElis a global real estate investment management firm that provides institutional investors and select other clients with a variety of real estate investment strategies. PREI has been managing real estate investments for clients since PREI is a 7.1

2 business unit of Prudential Investment Management (PIM) which itself is a subsidiary of Prudential Financial, Inc. PIM was registered with the Securities and Exchange Commission on June 6, As of March 30, 2012, PREI managed $51.3 billion real estate assets ($33.4 billion net) for approximately 400 investors. These strategies include: United States and International commingled equity real estate funds, real estate debt funds, separately managed real estate investment accounts, real estate securities portfolios, etc. As mentioned above, the Plan is invested in PRISA and PRISA II. PRISA is PREI's flagship core open-ended commingled fund that, as of June 30, 2012, had a gross asset value of $13.78 billion and a net asset value (less mortgage debt) of $10.84 billion. PREI pioneered the open-ended commingled equity real estate fund model when it launched PRISA in The PRISA portfolio management team includes 24 real estate investment professionals located in four offices: Madison, New Jersey; Chicago, Illinois; Atlanta, Georgia; and San Francisco, California. Each office possesses a regional expertise. The lead portfolio management team is located in PREl's Madison, New Jersey headquarters and includes Catherin Marcus - Sr. Portfolio Manager, Joanna Mulford - Portfolio Manager, Jameel Nabulsi - Portfolio Manager, and Nicole Stagnaro - Asst. Portfolio Manager. The average number of years of real estate experience as well as tenure at PREI for the lead portfolio management team is 15 and 14 years, respectively. PRISA II is a Core-Plus open-ended commingled fund that launched in As of June 30, 2012, the fund had a gross asset value of $8.21 billion and net asset value of $5.45 billion. PRISA II's investment team is made up of 19 investment professionals located in two offices: Madison, New Jersey and San Francisco, California. The lead portfolio management team is located at PREl's Madison, New Jersey headquarters and includes Terry McHugh - Sr. Portfolio Manager and Darin Bright - Portfolio Manager. Mr. McHugh and Mr. Bright have over 31 and 20 years of real estate experience, respectively. Investment Process and Risk Controls Mr. Billingsley met with Portfolio Manager, Joanna Mulford and Assistant Portfolio Manager, Nicole Stagnaro, to discuss the investment process and strategy for PRISA. Mr. Billingsley also met with Portfolio Manager, Darin Bright and Vice President, Justin Gleason to discuss the investment process and strategy for PRISA II. The investment objective of PRISA is to generate an absolute total gross return of % ( % net) over a complete market cycle. PRISA II's investment objective is to generate total gross returns of the National Council of Real Estate Investment Fiduciaries (NCREIF) Fund Index Open-End Diversified Core Equity (NFI-ODCE) basis points. PRISA constructs a broadly diversified equity real estate portfolio that is comprised primarily of existing income producing properties with strong cash flows. When constructing the portfolio, PRISA follows a property type and geographic diversification strategy that is intended to reduce risk. This diversification metric is based off the NFI ODCE benchmark and the fund's investment guidelines allow PRISA to modestly overweight and under-weight the portfolio relative to NFI-ODCE according to strategic views. As of June 30, 2012, PRISA's largest strategic allocations were a 4.7% underweight to 7.2

3 New York City and a 5.8% overweight to the storage property type, which is actually a property type not represented in the benchmark. From a financing perspective, PRISA controls risk by limiting the amount of leverage to 30% of the gross asset value of the portfolio as well as by restricting the makeup of the portfolio's debt. As of June 30, 2012, PRISA operated under 23.4% leverage of which 79% is fixed-rate and 86% is nonrecourse. In 2010, following the real estate downturn, PRISA strengthened their portfolio risk guidelines by instituting the following controls: 1) re-committing to 30% maximum leverage; 2) shifting the core/non-core ratio to 90/10 from 80/20; 3) instituting a 5x's debt to portfolio operating income multiple; 4) limiting recourse leverage to 15%; and 5) instituting a single asset exposure maximum of 5% of gross market value (GMV). As of June 30, 2012, PRISA was in compliance with all of these risk governors with the exception of the single asset exposure. PRISA owns two assets, which each represent 5.9% of the portfolio. One asset is a 1.9 million square foot office building called International Place that is located in Boston, Massachusetts. The second asset is a 1.1 million square foot office development called Eleven Times Square that was completed in 2010 and is located in New York, New York. PRISA II follows a similar strategy as PRISA with a modestly more aggressive valueadd component. PRISA's portfolio managers refer to their strategy as "manufacturedcore". Sixty-five percent of the PRISA II's portfolio is comprised of existing, stabilized income-producing properties. The remaining 35% is comprised of non-core properties that exhibit less than 80% occupancy at acquisition and typically require development, repositioning, or property management overhauls to achieve stabilized occupancy and/or rent growth. When developing properties, PRISA II executes its strategy with equity investments in joint ventures with local operating partners. PRISA II typically assumes an 85-90% stake, which grants PRISA II control over the asset. PRISA II is not subject to the same geographic and property-type diversification risk governors as PRISA. PRISA II limits risk according to: 1) a core/non-core mix of 65/35; 2) leverage limit of 40% of GMV; 3) recourse leverage limit of 20% of GMV 4) maximum single asset exposure of 5% of GMV; 5) maximum mezzanine investing of 10% of GMV; and 6) maximum of 5% land investing by GMV. PRISA II is in compliance with all the aforementioned risk metrics except for land exposure. As of June 30, 2012, PRISA II's land exposure was 7.7% of the GMV of the total portfolio. PRISA II is not pursuing any future land acquisitions and is putting 10 of its 28 land holdings into production as multifamily developments. This represents approximately 27% of the non-core portfolio as measured by GMV. As a result, PRISA II expects this metric to fall into compliance in All acquisition decisions, for both PRISA and PRISA II must be brought before the Investment Committee for consideration and approval. The Investment Committee is made up of a cross section of Sr. Portfolio Managers within PREl's United States real estate platform including PRISA I, II, and III, as well as PREI's Chief Investment and Risk Officer, Roger Pratt, and PREI's head of research, Dr. Yuogou Liang. The pipeline of new potential deals under consideration is formally presented by PREI's Transactions Group at weekly meetings. At these meetings, each respective fund's representative expresses interest in properties available and presents a case for investment. The investment thesis contains full underwriting assumptions including financing, acquisition 7.3

4 and disposition strategies, development and re-positioning strategies, and diversification suitability from a total portfolio perspective. In situations where multiple funds express interest in the same property, the decision is forwarded to the Allocation Committee. PREI emphasized that such conflicts are rare. All Investment Committee decisions are made according to a simple majority vote with Roger Pratt, Chief Investment and Risk Officer, wielding veto power. Once a deal is approved, the execution of the deal falls back into the purview of the Transactions Team. PRISA and PRISA II properties are subject to quarterly valuation by third-party appraisers. The appraisal process is overseen by the PIM Chief Appraiser who is independent from PREI and reports directly to the senior management of PIM. The Chief Appraiser retains an independent appraisal management firm to run the day-today operations of the appraisal process including appraiser selection, rotation, and termination. All appraisals are performed in accordance with the Uniform Standards of Professional Appraisal Practice and consider the conventional method of valuation (income, cost, and market). PREI supports the portfolio management of all its funds, including PRISA and PRISA II, with proprietary research conducted by PREI's 15-person research team lead by Dr. Youguo Liang. Mr. Billingsley met with Dr. Liang to discuss the interaction of research and portfolio management. Each fund at PREI is assigned a dedicated research analyst. All properties under consideration by a particular fund are funneled through the research analyst and the research team during the underwriting process. PREI's research team provides the portfolio management and transaction teams with market specific analysis including occupancies, rent levels, leasing and comparable sales, absorption and capture modeling, etc., as well as macro-level market and submarket economic and demographic factors. The research team also provides PRISA and PRISA II with backward and forward-looking portfolio diversification and attribution analyses designed to aid in overall portfolio construction. Performance Mr. Billingsley addressed the performance of PRISA and PRISA II with both funds' respective portfolio management teams. As of June 30, 2012, PRISA has generated a -1.40% IRR and a 0.93x equity multiple, distributing a cumulative total of approximately $9.6 million in operating cash flow, since inception. The primary driver of PRISA's underperformance since inception was the collapse in commercial real estate values in PRISA's portfolio value decline was enhanced by the use of leverage, which peaked in 2009 at 40%. During 2008 and 2009 specifically, PRISA generated annualized returns of -13.6% and -34.9%, respectively. The commercial real estate markets recovered beginning in 2010 and PRISA generated returns of 18.0% in 2010 and 19.1% in Year-to-date, through June 30, 2012, PRISA has generated a return of 5.74%, comprised of 2.65% income and 3.09% appreciation. PRISA expects appreciation returns to dampen through the remainder of the 2012 and projects total returns of 7.5%-9.5% (gross), comprised of % income, and % appreciation. This is consistent with PRISA stated goal of generating approximately 80% of returns through income. As of June 30, 2012, PRISA II generated a since-inception IRR of -1.92% with a 0.93x equity multiple, distributing a cumulative total of approximately $2.2 million in operating 7.4

5 cash flow. As is the case with PRISA, PRISA II's underperformance was driven primarily by a value decline of the underlying properties in the portfolio. The decline was enhanced by the use of leverage. In 2008 and 2009, PRISA II generated annualized returns of -16.9% and -45.7%, respectively. Since 2009, PRISA II has regained much of its lost value. In 2010, PRISA II generated a 23.2% total return and in 2011, PRISA II generated a 19.1% total return. Year-to-date through June 30, 2012, PRISA II has generated 8.36% total return made up of 2.34% income and 6.02% appreciation. Similar to PRISA, PRISA II expects the pace of returns to moderate for the remainder of 2012 and projects 2012 total gross returns of 12-16%. Fund Structure and Administration PREI is undertaking a legal restructuring of PRISA to expand the pool of investors eligible to invest in the Fund. Currently, PRISA is structured as an open-end insurance company separate account established under New Jersey law and offered through a variable group annuity contract issued by The Prudential Insurance Company of America, which is a wholly owned subsidiary of Prudential Financial, Inc. Under this structure, investors are deemed to hold interests in an annuity contract rather than the real estate assets themselves. This reduces investor liability and has favorable tax characteristics. However, the Internal Revenue Service and regulatory requirements only allow United States pension plan investors and other select tax-exempt investor to be eligible to participate in this investment vehicle. In an effort to open PRISA to additional investors, including defined contribution funds, PREI is re-forming PRISA as a limited partnership called PRISA LP. PRISA LP will be a Delaware limited partnership, which will invest alongside the current open-end insurance company separate account in a private Real Estate Investment Trust (REIT) Holding company ("PRISA REIT") which will then invest in the real assets. This new limited partnership structure will only be used by new investors into PRISA. The new investors will pay a management fee prernium of 106 basis points (vs. 100 basis points for existing investors). The terms and conditions for existing investors in the insurance company separate account, including the Plan, will remain the same. PRISA LP's initial closing date is expected to be January 1, PRISA II is not pursuing this same legal structure change at this time. Disaster Recovery and Business Continuity PREI operates 24 offices around the globe. Each office has its own detailed business continuity plan. PREI maintains the ability to shift work locations to other offices should localized emergencies render one location unavailable. Additionally, all PREI offices have established third party managed temporary worksites should the impact of any emergency extend to one or more local offices in the same region. In the event that alternate offices as well as third-party alternate locations are unavailable, PREI has established a system for key management employees to work remotely. PREI systems are controlled by SygateNPN/Secure Id and access to all PREI systems require password authentication, which is subject to frequent, but variable, updating. PREI also utilizes an enterprise software tool called Vontu that interrogates all movement of data at the desktop level and prevents the leakage of any personally identifiable information. 7.5

6 PREI utilizes more than 20 software, communication and data management systems. Most of PRISA and PRISA II's data systems are hosted at the following locations: PREI headquarters in Madison, New Jersey; Chicago, Illinois; and Dallas, Texas. Specifically, PREI's property/asset management system and portfolio management system is hosted by MRI software in Chicago. PREl's cash flow and valuation modeling system (Argus) is hosted on a Citrix server in I\lew Jersey headquarters and PREI's proprietary Property Deals Database is hosted at PREI headquarters in Madison, New Jersey. Prudential's Oracle-based corporate accounting systems are also hosted in New Jersey. Finally, PREI's valuation monitoring tool called PruVal is hosted by Real Estate Research Corporation in Dallas, Texas. This data hosting dispersion helps ensure that wholesale outages of multiple keys systems are avoided. In addition, all , file shares, voice mail systems, Blackberry servers, and databases such as those previously described are automatically replicated and backed up to alternate servers on a daily basis. These alternate servers are housed either in different PREI office locations or in off-site, third party, storage facilities. All of PREl's individual office business continuity plans are collectively overseen by Prudential Financial's Office of Business Continuity. The stated goal of the Office of Business Continuity is to restore all operations at all of Prudential's business units within hours of a business disruption. Summary and Findings Mr. Billingsley and management staff from PREI covered a comprehensive agenda with respect to various areas of the firm. Mr. Billingsley observed work in various areas of the firm and discussed portfolio management, risk controls, research, performance, fund structure and business continuity while speaking with multiple key personnel. From Mr. Billingsley's perspective, the PREI team effectively covered all investment philosophy and management issues associated with management of PRISA and PRISA II. Mr. Billingsley did note the heightened level of portfolio risk that both PRISA and PRISA II exhibited prior to, and during, the real estate downturn in 2008 and Both funds took corrective measures to mitigate this risk going forward. Otherwise,. Mr. Billingsley did not observe any issues of concern during his visits. Jeremy Wolfson Chief Investment Officer SB:JW:SV:DB 7.6