SAN FRANCISCO—Many pension funds and other institutional investors allocate commercial real estate investment funds into the three property risk classifications of core, value-added and opportunistic and then into various markets and property types. Allocation into these risk classifications is necessary; however, it should be the second step in a more comprehensive allocation investment strategy. 

A comprehensive investment allocation strategy should begin with the four quadrant approach to real estate investment. The four quadrant approach for CRE investment strategy was written by me in the summer 1995 issue of Real Estate Review magazine as well as others from Heitman Properties Ltd. and Property, Portfolio and Research during that time. The approach first allocates the total investable capital to CRE between the public and private real estate markets and then into debt and equity investments within each of those markets. The public CRE equity market is comprised of REITs and real estate operating companies (primarily hotel companies) and the private equity market includes all other non-public CRE investment programs including non-traded REITs, private equity funds, closed end funds, commingled funds and special account funds. The public CRE debt market is comprised of CMBS loans and the private debt market includes all private financing from banks, savings and loans, Wall Street, mortgage bankers and private lenders that issue first mortgage loans, subordinate loans, mezzanine loans, bridge loans and participating loans. A graphic representation of the four quadrant investment program is shown in Table I below:

Table I-Four Quadrant Investment Program

Once funds are allocated to the four quadrants, the next step is to allocate the private equity portion to the three risk classifications of core, value-added and opportunistic, the public equity portion to REITs and the debt portions to public and private categories as desired. Some may question including public REITs in the CRE sector as opposed to the stock equity investment sector of an institutional fund, as REITs shares have had a 74% correlation with small cap stocks. However, many practitioners believe that public REITs should be included in the CRE sector because they provide liquidity, transparency, long term returns similar to private real estate equity and when included in the four quadrant program, increase return and lower risk. According to a Summer 2011 article written by E. Todd Briddell, President and CIO and Alan Supple, Portfolio Manager of Urdang Securities Management, including public REITs and private real estate equity in mixed asset portfolios produces an efficient frontier line the moves up and to the left which results in a higher yield at lower risk or standard deviation.

The final step in the four quadrant investment program is to diversify by geography, industry and property type. A summary of the steps in a comprehensive four quadrant investment approach for a $200 million CRE allocation with proposed percentage allocations are as follows:

• Determine investment allocation, leverage and return requirements from the fund's investment policy statement
• Allocate funds to achieve investment levels of 50% in private equity, 25% in private debt and 25% in public equity
• Allocate private equity to core (33%), value-added (33%) and opportunistic (34%)
• Diversify private equity investments by property type, geography and industry
• Diversify debt investments by property and loan type
• Select real estate managers for fund allocation

Institutional investors should consider the four quadrant investment allocation strategy as the base and cornerstone of their CRE investment program. Use of this allocation strategy will lower portfolio risk and increase returns.

Joseph Ori is executive managing director of Paramount Capital Corp. The views expressed in this column are the author's own.