How Vince Smith at New Mexico State Investment Council is Using Real Estate to Weather Late Cycle and Rising Rates

Changing economic environments warrant evolving investment approaches. Implementing and refining new strategies is exactly what Vince Smith, CIO at New Mexico State Investment Council (NM SIC), has been working on in the state fund’s real estate portfolio over the past several years. NM SIC manages New Mexico’s $23 billion sovereign wealth fund, which produces hundreds of millions of dollars in educational and budgetary funding for the state annually ($968 million in fiscal year 2019).

With the economy late in the cycle and interest rates on the rise, some managers have started to moderately shift their exposures away from stocks and longer-duration bonds toward alternative investments such as real estate.

In the third quarter, the council approved an increase in its real estate allocation from 10% to 12%. This calls for a pacing of approximately $90 million in core and $248 million in non-core commitments in 2018. Projected annual commitments for the years 2019 through 2024 gradually pick up from $257 million to $305 million.

“We still like this [real estate] space relative to the other places that we’ve had to invest in,” said Smith. “One of the reasons real estate is at 12% now is really a diversification effort on our part to move away from investments that rely quite extensively on capital gain for their total rate of return and more toward investments that produce income as a big component of your total rate of return. Real estate fits that profile for us for late-cycle investing.”

Investment consultants typically take steps to adjust clients’ portfolios throughout the economic cycle. “What we’re seeing in the market, it’s top-of-the-cycle right now,” said Paul Kolevsohn, principal and head of North American Real Estate at Mercer Investments. “It’s difficult to find those really high-returning investments or dislocations that we saw in the market several years ago where double-digit returns were fairly common to come by.”

He said the economy is still improving in some respects, but he expects a correction within the next few years: “We’re not sure how severe, but in order to protect against that, we’re taking certain steps.” As a result, he favors diversified portfolios where certain types of investments will perform better late in the cycle.

This means reducing exposure to traditional property types like office and certain retail locations and looking at less GDP-driven investments, including niche property types like medical office, senior housing, and self-storage.

This shift is also reflected at SIC. In its core portfolio, which is currently at about 60% of total real estate and is a bit more conservative than its public pension funds peer group, noted Smith, it’s slightly underweight office space and slightly overweight multi-family. In the non-core space, SIC has been expanding a bit more overseas in Europe and Asia. The core/non-core mix will be closer to 55%/45% once commitments are drawn.

Since the rebalancing in 2011, SIC’s real estate allocation returned 10.6%, 12.3%, and 13.4%, respectively, over the past one, three, and five years at end of 4Q17. It’s outperformed the ODCE benchmark by approximately 390 basis points, 290 basis points, and 290 basis points, respectively.

SIC’s real estate program started in the 2004-2006 period, but due to high valuations at that time, it was mostly in opportunistic assets. Performance suffered due to the financial crisis, and in 2010, real estate allocation dropped to just 3%. In 2011, Smith started to rebuild the program, targeting a total real estate allocation of 10% and adding core assets to a portfolio where previously none had existed. The low-valuation base helped performance since then, though it’s slowed down a bit recently like in the rest of the sector.

Strong performance in the core space during those years also allowed SIC to make commitments in the non-core space, noted Smith, “that now is coming through for us.”

Jack Crews, managing director at JLL, said he hasn’t necessarily seen an impact on pricing in the better-quality assets due to the rate hikes of the past two years, “but it’s certainly on the forefront of everybody’s mind when you look forward to the next five to 10 years.”

He also pointed out that core assets tend to fare better throughout various cycles because they’re less volatile. More opportunistic allocations carry more risk as those asset buyers may use debt to finance their purchase, which becomes interest-rate sensitive as rates go up. Crews said that “the astute investors, funds, and operators are always watching that carefully,” though sometimes there can be a bit of a lag time.

New tailwinds can also possibly explain the extended length of the current cycle and positive dynamics in real estate, noted Alan Synnott, global head of research and product strategy for BlackRock Real Assets. Those include a growing student base and an aging population, expanding ecommerce, as well as new technological developments that drive the demand for more co-working spaces and other novel structures.

“We prefer assets that either offer predictability of income, a complexity premium, or play into a narrative of addressable long-term structural change,” he said. “So, the demographic trends, sustainability trends, or technology trends.”