Prof. Joe Pagliari, Jr. of Chicago Booth recently moderated a PREA roundtable.

1. 34 PREA Quarterly, Fall 2010
InvestmentRisk
Jon BraeutigamJoe Pagliari Keith Barket
C O V E R2010fall
TheChangingInvestmen
A R o u n d t a b l
Economic Environment
Pagliari: Let’s start with your firm’s take on the
general investment climate, your views on the
capital market as a precursor to how we think
about changing real estate investment man-
agement practices. Keith, could you give us
your view or your firm’s view?
Barket: Our firm’s view is not dissimilar from the
general consensus, which is that this has been a long,
deep recession and will be a slow recovery for all the
obvious reasons. We do believe there will be a recov-
ery, whether there is a second dip or not. I don’t think
we have a better vision than anyone else, but the signs
are pretty clear that we have been in the early stages
of recovery for six months or more. Almost all
the indicators—retail sales, industrial produc-
tion, manufacturing capacity, auto sales, even
employment, as much as we are all disappointed
by employment—are all positive, though they are
weaker than one might expect at this stage of a reces-
sion. We constantly watch for signs of a double dip,
and if we saw such signs, we would reevevaluate our
investment approach accordingly. However, we’ve
been very active buyers for the past 12 months, and I
don’t think we will come to regret it.
In terms of what the recession means for real estate:
First, it means that for the first time in 20 years, you
have an enormous amount of distressed assets working

2. PREA Quarterly, Fall 2010 35
Jamie ShenPat Halter Glenn Lowenstein Marc Weidner
tManagementBusiness:
e D i s c u s s i o n
their way through the system. The estimates of $500
billion to $1 trillion of loans that won’t be able to be
refinanced at today’s levels are consistent with our pro-
jections. Many of these loans will default, and a lot of
them already have defaulted. They will work through
the system as those real estate assets become recapital-
ized. From that perspective, we think it is going to be a
tremendous opportunity.
Thanks. Jon, the view from Michigan?
Braeutigam: I’ll give you my view, not Michigan’s view.
I won’t speak for all of Michigan, but I think double-dip
recessions are rare historically, so our base case would
not be a double-dip recession. Our view is probably
similar to consensus, which is we are in the “new nor-
mal,” or slower growth, camp. In terms of the broader
market, bear markets over the last 50 years have aver-
aged about 14 months. Average bull runs are 68 months,
and we’re about 17 months into that, so we think we
could be in a longer-term bull market, which would be
good for the economy. Commenting on deflation and
inflation: We don’t think we will see deflation, but we
are going to see very low inflation for quite some time.
Pat?
Halter: We are definitely seeing a period beset by os-
cillating views of both risk aversion and risk taking
as we look at the markets today. We don’t really see a
double-dip recession on the horizon. My general view
is that the economy is on track for a positive growth
of perhaps 2% for the third and fourth quarters of
2010—admittedly unexciting but growth nonetheless.
Probably, like Jon, I don’t think we are seeing a period
of sustained deflation pressure on the horizon, but that
is something to continue to monitor. I don’t want to
shine too optimistic a light on things, but calendar year
2011 may contain the seeds of a more promising year
for the U.S. economy, particularly if policy errors can
be avoided. That is one of the key things that we feel
has been a problem over the last 12 to 18 months. Our
forecast is for GDP growth to reach around 3% in 2011.
We do think unemployment rates will start to decline
from the 9½-ish range that they are at right now and
hope they will end up closer to the 8¼% range by year-
end 2011. Some interesting developments will start to
create job growth. One of the key ones is that labor
productivity has declined. Typically and historically,
stronger forces of job recovery follow that, albeit with
a lag. We’re hoping that that starts to transcend itself in
2011 because in real estate, we are all concerned about
the job growth outlook to an acceleration in job cre-
ation. We hope to see a bit more positive trend line in
that going forward. It is actually interesting; people are
complaining about where the jobs are, but if you look
at the current trajectory of private-sector job growth,
what we are experiencing now in the last 12 months
... this has been
a long, deep
recession and
will be a slow
recovery for
all the obvious
reasons. I don’t
think we have
a better vision
than anyone
else, but the
signs are pretty
clear that we
have been in the
early stages
of recovery for
six months
or more.
Keith Barket

3. 36 PREA Quarterly, Fall 2010
cover2010fall
coming out of this recession is pretty similar to the last
two post-recession recovery periods. So private-sector
job growth is not really out of pattern from past reces-
sionary periods.
I’d like to drill in a little bit further. You men-
tioned policy errors.What specifically concerns
you from a policy standpoint?
Halter: It is predominantly the uncertainty from the
Obama administration and the continued anti-busi-
ness attitude the Obama administration has toward
businesses. Obviously, health care has created a lot
of uncertainty in terms of the cost of business, the
cost of hiring people, and that is a significant factor
in terms of businesspeople thinking of adding or not
adding people.
Dotheforecastsofdeficitsenterintothatthink-
ing as well?
Halter: Forecasts of deficits are definitely a long-term
consideration, but obviously, the low level of interest
rates and the continued accommodating policy of the
Fed right now are pro-productive in terms of getting
economic activity going again.
Thanks. Glenn?
Lowenstein: Out of 100% probability, there is a 40%
probabilitythatweareinanemia,whichisjustflatto1%;
a 40% probability that we have a double dip and possi-
bly will go negative on some of the key indicators; and
a 20% chance that we come out of this OK. If we had to
attach one word to what we are going to experience over
the next six months to three years, it is anemia.
But either way, you are pretty bearish. You put
only a 20% probability …
Lowenstein: Yes. I don’t call that bearish—I call it realistic.
OK, fair enough. One man’s realism is another
man’s bearish. …
Lowenstein: Sorry to be so direct, but I don’t see the
creation of quality jobs. Most of the profits coming out
of corporate America are not being generated in the
United States; they are being generated internationally.
If you look at who is really creating value, what loca-
tions in the United States real estate investors can invest
in, you’re down to 10% to 20% of the traditional loca-
tions for investment. It is going to take us a while to
deleverage and get real productivity back online.
How about inflation versus deflation? Do you
have a firm view on that?
Lowenstein: We are not economists, but I would say
we see a three-year period where it is really difficult to
raise prices, broadly speaking. There will be some price
increases and niches here and there in different parts
of the economy. I don’t see super deflation. Then, ulti-
mately to deleverage, we will need to have inflation. In
summary, we do not see deflation, but minimal infla-
tion, 0% to 1% once again for three years and then some
real inflation.
Jamie, a view from Callan?
Shen: We believe that this is, as Keith started off say-
ing, a long, deep recession with a slow recovery. As there
is so much capacity in the system right now, we don’t
think there is an immediate threat of inflation, but we
also agree that the supply of money can become a factor
down the road. We are talking with our clients about
how to be thinking about inflation. Though no asset
class is a perfect hedge for inflation, some asset classes
might perform better in an inflationary environment,
and real estate is obviously one of those. We are looking
at client portfolios and looking at adding asset classes
that could perform better in an inflationary environment,
like real estate, timber, agriculture, TIPS, commodities,
and private energy funds.
Thank you, Jamie. Marc, please finish off
this discussion.
Weidner: I would differentiate between the developed
markets and the emerging markets that continued to
benefit from high growth rates.We are cautiously opti-
mistic on the U.S. economy and, at the very least, are
underwriting a very modest recovery in the U.S. and in
Europe. The double-dip probability has gone up recently,
butitisstillarelativelymodestandlowprobability.What
is interesting is that the center of gravity of the world
economy is shifting to the East. While the U.S., Europe,
and other developed countries have experienced a very
hard recession, there have been many places where it
was barely a blip on the radar screen, including Australia,

4. PREA Quarterly, Fall 2010 37
China, and India. That shift is likely to continue, but that
may actually have a positive impact on the U.S. economy,
which to a large extent is still very integrated into the
global economy. So we are cautiously optimistic over the
long term, and we certainly see today’s environment, in
which there is a lot of uncertainty, as an opportunity to
take advantage of market inefficiencies.
Inthedebatebetweendeflationandinflation,theglass
has been either full or empty and there has been a back
and forth between fear of inflation and fear of deflation.
It seems we passed from a scenario where inflation was
at the top of everybody’s agenda to a scenario where de-
flation is now at the top of everybody’s agenda. That shift
was only a few months ago if you look at headlines and
research papers; now everybody is focused on deflation.
We are likely at some point to get out of the deflation and
depression mood that we are in and start worrying about
the deficits and higher interest rates again. Therefore,
inflation might become an issue again, which to Jamie’s
point, might be actually very good for real assets, like
infrastructure, as well as for real estate.
Thank you, Marc.
Real Estate Strategies
Given everyone’s economic backdrop, let’s
move to real estate investment strategies and
talk about how the strategies themselves are
changing. I’ll ask Jon to comment first.
Braeutigam: First, in the market, there definitely has
been a shift toward core and value-added, especially after
many opportunistic investments over the last few vintage
years have really been troubled. But investors are still put-
ting money toward opportunistic strategies, definitely in
the distressed or fixed income side or direct loan side of
the equation; everybody is looking there for opportunity
and higher returns. They are also looking internationally,
but I would say Asia and maybe Brazil; they are not look-
ing toward Europe right now. Michigan has mirrored that
as well. We’ve always had an emphasis on core and value-
added, and we have some opportunistic. For us, it is re-
ally no shift; the strategy would be continuing that. I think
thereisanemphasisoncurrentincomeversustotalreturn.
Right now, the State of Michigan Retirement System has
to pay out net of employer contributions about $2.4 bil-
lion every year; that is about 5% plus of our whole portfo-
lio. At some point, you need income so you can help pay
the benefits. That is one reason we have an emphasis on
current return. When we look at the market, it could be
attractively priced in the U.S. if you look at the spread of
cap rates over ten-year Treasuries, which are near historic
highs. We know we are buying real estate assets below re-
placement cost. We know we are not in a period similar to
2006–2007;today,thecapratesaren’tincludingpayingfor
the vacancy; there is no assumed lease-up on that vacancy
in today’s market. All that makes for a fairly attractive asset
class for a part of a broader portfolio.
Jon, just as a frame of reference, how does the
5%payouttodaythatyoumentionedcompare
to where it was five or ten years ago?
Braeutigam: Since becoming CIO, have I have not
gone back to look at the net payout over the last decade.
But many times, states—and Michigan is no different—
look to solve their general fund budget deficits with
early outs. That helps the immediate need of the general
fund of a state, but it puts more burden on its pension
system. So those payouts could even increase a little bit
further with early outs. Michigan just had an early out
for our public school employees, and 17,000 people
took it. A normal year would be much fewer than that
in terms of retirees.
Thanks. Pat, how are the real estate strategies
changing at Principal?
Halter: In general, opportunities for core exist today,
and you should be truly accumulating core properties;
we believe we are either at or near the market bottom.
Accumulation is more favorable with dollar cost averag-
ing approaches; that is our view of how to implement
and put money into the market right now. It is clear
that a couple of indicators truly are substantiating put-
ting money into the market now. One, over the last
three or four years, property values have declined much
faster and further than income on properties, which we
think suggests a buy signal for core. Obviously, current
spreads of cap rates to risk-free rates are at their widest
level probably in eight or nine years. So core is where
we are focusing a lot of our energy right now. I think the
other thing that is important is where transaction and
volume are right now. Our view is that the broader uni-
verse of buying opportunities is likely to expand over
... the center of
gravity of the world
economy is shifting
to the East. While
the U.S., Europe, and
other developed
countries have
experienced a very
hard recession, there
have been many
places where it was
barely a blip on the
radar screen. ...
That shift is likely
to continue, but
that may actually
have a positive
impact on the
U.S. economy.
Marc Weidner

5. 38 PREA Quarterly, Fall 2010
cover2010fall
the next few years both from an increased pace of reso-
lution of troubled loans and from more non-distressed
sellers bringing properties to the market as values begin
to move off the bottom. We think a lot of that activ-
ity will be in core initially. So just from a transaction
perspective, we think that is where a lot of the activ-
ity will be. There is a pretty significant bid-ask spread
differential for value-add and opportunistic investments
in terms of a seller’s willingness to sell at a price and a
buyer’s willingness to buy at that price.
In terms of some specific areas of general focus rela-
tive to core, from our perspective, trying to buy core
buildings in an off market or limited-bid transactions is
really the key to the strategy. A lot of these—whether it
is Eastdil or CB Richard Ellis—deals are being bid out,
and there are 25, 30 bids on each transaction out for
core. You want to try to avoid that, try to find off-market
deals if at all possible, and consistently be conservative
onleverage,althoughIthinksomeleverageisgoodtoday,
and 30% to 50% loan-to-values for fixed-rate financial
leverage on new acquisitions is a prudent strategy, as is
focusing acquisition activity on demographically strong
markets. Even though there is a history of excess supply,
the Southeast and parts of the Southwest look interest-
ingtoustoday.Wereallylikepositioningourinvestment
into LEED-certified properties and some geographic ar-
eas with favorable supply constraints, such as the Pacific
region, because they have strong demographic drivers,
yet are of interest to us. So core is where we are spend-
ing most of our focus at this point; we think that is the
best opportunity on a risk-adjusted basis.
Pat,howdoesthatcomparetowhereyouwere
four years ago or so?
Halter: We were doing a lot more value-add at that
point in time along with core.
And Glenn, with your “realistic” view, not your
“bearish” view, how are your real estate strate-
gies changing?
Lowenstein: We keep the same strategies. We don’t
call them core, value-added, opportunistic; we call
them low risk, medium risk, and high risk. I’m actu-
ally seeing opportunity in all three of them. Here is
the way I would frame each of them. In the core seg-
ment, it is true if you get a fully bid asset, your yields
are low, but some of the real estate that is in high de-
mand by capital and tenants is what we would call “a
bridge over troubled waters.” With low leverage, ex-
actly as just was said, you can get a sustainable plus
7% cash on cash that grows nicely over ten years. We
like that as a hedge against a slow economy, and we
get inflation protection. Then when it comes to value-
add, there is a huge spread between a stabilized cap
rate on a transitional asset and a core stabilized asset.
It is the biggest I have ever seen in my career. So you
can buy a less than 75% leased asset for 50% of peak
pricing. Now granted, there are not a lot of trades, so
you wouldn’t design a whole strategy around it, but
there are absolutely good investments to make. In the
opportunistic space, we see pricing at 20% of peak
value, so our overall theme is “price to anemia.” If
you take the realistic view that we are flat or down for
three years with a gradual rise out, and you can price
to that scenario, then you can make money and make
a good investment without principle risk on all three
of these categories. The most volume in the next two
years will be in core, then value-add, and then oppor-
tunistic, in our view.
Jamie, what real estate strategies is Callan
recommending?
Shen: We do everything on a client-by-client basis,
and it really is dependent on the client’s objective. We
try to meet clients’ objectives by taking on the least
amount of risk. Today, we are favoring core invest-
ments because we believe they can meet the return
objectives utilized in asset allocation for the asset class
by investing predominantly in core. For 2010 year-to-
date, through our search process, we have allocated
82% of capital to core strategies, 9% to value-add, and
9% to opportunistic strategies.
Whenyoutalkabouttheinvestmentallocation
models and real estate’s role within them, is it
still the case that you look at it as an inflation
hedge, an attractive current return, and offer-
ing some diversification benefits? How has the
thinking evolved, if it has at all, with regard to
real estate’s role in a mixed-asset portfolio?
Shen: We view real estate as a strategic placeholder in
our asset allocation model, and that view has remained

6. PREA Quarterly, Fall 2010 39
constant. We have always looked at real estate as being
something between fixed income and equity on both a
risk and return basis. We like the current income aspect
of real estate and the potential for some appreciation. I
think the industry began looking at real estate as provid-
ing more alpha or more private equity type of return,
but we continue to believe that real estate is more of a
diversification play and should offer investors current
income with some low level of appreciation.
Thank you. Marc, let’s swing toward your view
of the real estate investment strategy world.
Again, give us both the domestic and interna-
tional views.
Weidner: Sure. Over the last five years, we became in-
creasingly cautious about the United States to the point
where we stopped investing in the U.S. market altogeth-
er about two and a half years ago, while our investment
programs elsewhere in the world actually were being in-
creased. We are coming back to the U.S. market. There is
obviously a great opportunity here if we are being selec-
tive. Our strategy for the U.S. market is focused on high-
quality assets trading at substantial discount to replace-
ment cost. When selecting managers today (we are multi-
managers), we find managers that can capture core or
core-like assets outside of competitive bidding situations.
One of the characteristics of today’s market is that a lot of
stressed and distressed situations reside with the owners
and/or the structure of the ownership of the assets, when
there is actually nothing wrong with the assets. We think
this is a particular point in time that is unusual in a cycle
where you can access well-leased, well-built, and well-
located assets in these stressed or distressed transactions
at a substantial discount to replacement cost. Although
volume for these types of transactions is low because it
is obviously complicated to extract these assets from the
current ownership, we believe that the investors focused
on that opportunity will be handsomely rewarded on a
risk-adjusted basis.
Keith, earlier you talked about “distressed”
real estate. Can you talk a little bit more
about that in light of your real estate invest-
ment strategies?
Barket: Sure. We manage a series of opportunistic and
core-plus funds—core-plus meaning the lower-risk,
value-add strategy. The next few years will be a great
time to pursue those strategies in the U.S. Unfortu-
nately, many investors fell in love with opportunistic
and value-add strategies in 2005 to 2007. There was
too much capital chasing those strategies, and alloca-
tions were too heavily weighted toward opportunistic
and value-add for many investors. I think we are seeing
a swing back toward rebalancing where core becomes
the dominant part of a larger investor’s real estate port-
folio. I believe that is appropriate. However, I do believe
that a good manager, a manager who is really skilled at
adding value to real estate, will outperform core on an
apples-to-apples, unleveraged basis over a long period
of time and will probably significantly outperform. A
manager who is not so skilled could significantly un-
derperform. We are seeing a little bit of both right now
as we go through this recession.
Keith, would you agree with this statement: In
otherpartsofthecapitalmarket,thedispersion
among investment managers’ performance
widens with the riskier strategies?
Barket: Yes.
Glenn?
Lowenstein: Our approach starts with demand for
space. We look at the nation in terms of locations that
will gain more than their share of demand over the long
term and where new supply is limited. Then we look at
relative capital scarcity. Through these two lenses, we
see potential for investment in our low-, medium-, and
high-risk strategies.
Fee Structures
Let’s move next to fee structures. In most fall-
ing markets, there are downward pressures
on fees, and real estate is not an exception
to that general rule. Pat, will you start the
conversation talking about where fees have
moved to over the last 12 or 24 months?
Halter: A perfect storm is brewing from an advi-
sor perspective; advisors definitely have less pricing
power for the reasons you mentioned, Joe. With a
down market and performance from advisors subpar,
it is difficult to see fees sustaining at current levels.
From an investor perspective, many of our investors
For 2010 year-to-date,
... we have allocated
82%, of capital to
core strategies, 9%
to value-add, and
9% to opportunistic
strategies.
Jamie Shen

7. 40 PREA Quarterly, Fall 2010
are public pension plans, corporate pension plans,
and other institutional investor plans that have ei-
ther unfunded issues or, if they are part of a govern-
ment body, significant budget deficits. There is this
intensive pressure on boards and vis-à-vis staffs to
renegotiate fees with advisors on existing mandates,
let alone new mandates. There is definitely a move-
ment in repricing fees in the marketplace.
In the marketplace discussion today, and at a re-
cent conference I attended, much of the discussion
centered around the best fee structure in alignment.
A significant amount of discussion centered around
what sort of benchmarking structures should be in
place relative to incentivizing the right types of be-
haviors by advisors and how they should align with
the investment strategy and with staff compensation
structures. This whole fee structure continues to be
fluid and always have new twists and turns to it. The
movement in fee structures is definitely downward.
This is not directly associated with fee structure, but
it is interesting: The financial services reform act and
the Volcker Rule will cause institutions to look at their
proprietary trading investment portfolios and where
they are actually putting money into funds. There is
going to be some profound pressure and change in
terms of how much co-investment opportunity funds
in particular and other funds are going to be able to
place in terms of new investment funds. That is going
to have a profound impact on investors’ willingness to
pay significant incentive fees if that co-investment capi-
tal is less or is not offered. That is another interesting
dimension to follow over the next couple of years.
Jamie, maybe you can follow up Pat’s discus-
sion about fees since, I believe, you were at the
same conference.
Shen: There is pressure on fees. Any disruption in the
market highlights issues that may not have been foreseen
or that may have been foreseen but were downplayed; the
thinking was that these situations would not occur. Over
thenextfewyears,wearegoingtocontinuetoseesomeof
the shortcomings of the in-place fee structures and where
some of the misalignments exist. One area in particular
is on carried interest and how and when it is paid. The
investors are very focused now on wanting portfolio-level
distributions where they receive all their capital back first
cover2010fall
before the manager receives any incentive fee. We haven’t
seen all the true issues from the previous fee structures
come to light. Specifically, we are going to see some chal-
lenges or continued challenges where some incentive fees
weretakenearlyoninafund’slifeandhowthosewillneed
to be paid back to the investors. As pressure builds on
fees generally and fees come down, questions will be ex-
plored in great detail by investors, consultants, and invest-
ment managers, such as “What is the right compensation
for investment management professionals?” “How much
can they be compensated?” “What are the firm economics
with the new fee structures without embedded incentive
fees in their current funds coupled with even more back-
ended fees in future funds at this point?”
Other outstanding questions are related to the tax
changes for next year and incentive fees in the future
being taxed as regular income versus long-term gain.
Will investment managers try to demand a higher per-
centage of sharing? I don’t think the investors will sup-
port that. Is the investment management industry going
to have some type of wage deflation? Is it going to be
a less-profitable business? What are the long-term im-
pacts of that, and are we just in a new era where the
compensation is going to be lower than the promise of
the compensation over the last five years? There are a lot
of issues related to the fee structure, and a lot has yet to
run through the system and run its course.
Jamie, just a couple points of clarification.
There were some promoted or carried inter-
ests distributed early on in a fund, and inves-
tors are looking to claw back those earlier dis-
tributions. Was there a clawback provision in
the investment management documents? If
there wasn’t, are the investors just demand-
ing it because they think it is the right thing
for an investment manager to do?
Shen: In most cases, there is a clawback provision,
however, they haven’t been triggered yet because
many of the funds have remaining assets. That is
what I mean by it still hasn’t been played through
the system, but there is an expectation that many of
those clawback provisions will be triggered.
Could you roughly quantify the reduction in
base fees and/or the preferences? In other

8. PREA Quarterly, Fall 2010 41
words, are fees down by 25 basis points?
Have preferences gone to 10% from 8%, as
one example? How should we think about
those two dimensions?
Shen: Broadly speaking, the base fee in some
cases has remained constant; in some cases, the
committed capital fee has reduced from 25 to 50
basis points during the commitment period but
then switched to the traditional 1.5% on invested
capital. In some cases, where maybe the preferred
return was at 8%, it has come up to 9%. We are
seeing very few 8% preferred returns anymore; we
are usually seeing 9% or 10%. We are also seeing
a lot of tiered structures on the promote where
there might be a first hurdle and then the manager
gets a lower percent of the profits, say 10%, and
then a second hurdle and the percentage sharing
will increase.
What about co-investment and gover-
nance structures?
Shen: We are seeing some more creative things be-
ing done to improve alignment or have more of the
return coming to the investors. I don’t know if it is a
better alignment from the manager’s perspective, but
the investors are trying to protect themselves a little
bit more on the downside.
Thank you. Glenn, back to you.
Lowenstein: We just did a large transaction setting up a
joint venture with a major fund, and what Jamie said was
dead on. My global comment on fees is if you want to be
an investment manager for the next 20 years, you really
have to love this business and have to be a lifer because
the low fruit has been picked in the past 20 years. The
way I would summarize the market is that the current
fees are going to be, as best as people can measure, ap-
proaching cost. The incentive fees are, as best as people
can structure them, going to create alignment, and we
will see a lot of creativity in this area of compensation.
When it comes to discretion, there will be more struc-
tures that have partial discretion at different points along
the deal cycle. I don’t think it is negative at all for this to
happen. I think what you will see is professionals who
really want to be great investment mangers stick with
the business, and people who are in it just for the money
may or may not last. My final comment is that you are
going to see tiers of firms form where the top 25% that
are recognized as best in the business will have pricing
power and the other 75% won’t.
Marc, you are in an interesting place, hav-
ing the ability to look both domestically and
internationally at a variety of investment
managers and funds. What do you see with
regard to fees?
Weidner: In terms of fees, our approach is really to
align interests between the investors and the managers,
and obviously, that is a moving target. For the base fee,
we like to dig into the cost structure—whatever that
structure is—and the organization of the manager and
try to find a base fee structure that covers only the real
cost of operating the business and is not a significant
component of the profit. One of the issues with the
current model is the assumption that these managers
will be able to raise funds indefinitely. One of the unex-
pected consequences of the current fee structure is that
if your current fund-raising effort is delayed (and this
has been the case for almost everyone), your revenue
will go down automatically, and you may run into trou-
ble in your prior funds as well because the investment
management fees they generate are actually not cover-
ing the costs of managing these prior funds. They cost
much more to manage than the revenue they generate,
especially if the value of the assets has come down. In
today’s environment, you want to be fully staffed when
it comes to asset management, so the reality is that a lot
of managers have been forced to cut corners because
they cannot properly fund their operations and there-
fore make things even worse. In the past, this operating
deficit was sometimes funded by the incentive fees, but
that is gone now.
The incentive fees we like are the back-ended struc-
ture and the tiered approach where performance fees go
up progressively as realized returns go up. Something in
particular we are pushing back on quite a bit with some
success is the catch-up; is it really normal for the man-
ager to benefit from a full catch-up at 12% or 13% of
realized return? It seems to us a disproportionate share
of the profit. If real excess returns are being generated,
then perhaps, we can have a catch-up later or a higher
amount of promote.
... if you want to be an
investment manager
for the next 20 years,
you really have to
love this business
and have to be a lifer
because the low fruit
has been picked in
the past 20 years.
Glenn Lowenstein

9. 42 PREA Quarterly, Fall 2010
I also want to comment on what Glenn just men-
tioned about pricing power. At the same time that there
is downward pressure on fees and that for the first time
in many years LPs have pricing power, the best man-
agers are also only emerging today because it has been
difficult in an upward-only environment to differentiate
the good, the bad, and the ugly managers. Everybody
performed well. Nobody lost money until everybody
started losing money on paper, and now we really are
starting to see which managers can weather the cycles
and make money on a consistent basis. These managers
are actually going to attract more funds, more capital and
will certainly be able to maintain or even increase their
fees. It will be a mistake in this environment to focus on
only cost at the expense of the quality of the manager.
Keith, from a value-added/opportunistic point
of view, how do you see fees changing?
Barket: We actually just raised an Asia fund, and it was
interesting—Marc touched on this—in due diligence,
we had investors who wanted to understand our cost
structure compared to our fees. Every time they asked, I
wasn’t sure whether they wanted to see if we were mak-
ing too much money or not enough. Investors were ac-
tually concerned about both, as many wanted to make
sure we were making enough to adequately staff the
fund. We did not get push back on our fees for this new
Asia fund compared to the prior fund.
If I were an investor, there are a few things I would
focus on. First, I would push back more on the base
fee than the incentive fee. The 1½%, 1¾% fees that
most U.S. funds charge on committed capital might be
aggressive. I also believe that incentive fees should be
back-ended at the fund level, not paid on a property-
by-property basis.
On the other hand, if LPs were to push to drastically
cut fees—and I don’t see this happening—the man-
ager risks losing significant talent. The really smart tal-
ent would ultimately move to other industries—hedge
funds or private equity shops.
Jon, as an investor, what do you see?
Braeutigam: Real estate is just one component; you
have other asset classes as well. Everybody has covered
this topic really well, so I will try to be brief. There could
be tiering; there will definitely be changes on how to
pay. We are in a low-return environment going forward,
maybe in all asset classes, especially with the ten-year
Treasury sitting at 2.7%. What that will do is create an
environment where there is less return to pay people,
an environment where boards and chief investment
officers are trying to bring more back to the fund. So
there is a downward pressure on fees. The push back
to that is that you want to invest with quality manag-
ers, and quality managers, as Marc mentioned, have
proven themselves in this cycle when times have been
really bad, so they will have pricing power. The market
will end up where it is at give or take; the LPs, such as
us, will be pushing for lower fees because we think we
are in a lower-return environment. The GPs who have
proven track records will bring those track records with
them and say, just as Keith mentioned, “We need to at-
tract highly qualified people, or they are going to go and
do something else.” We do see, even in hedge fund land,
asKeithmentioned,largerfundsnegotiatingsomelower
fees. At the end of the day, you will see some lower fees.
Some of the companies that have great results will keep
their fees where they are, but in general, the industry
will have lower fees, whether that is base or incentive or
a combination of both.
Barket: The other thing people will take a look at is,
what other sources of fee income does the manager
earn? The investment management fee is very trans-
parent, but in some cases, managers were charging ac-
quisition fees, asset management fees, financing fees,
and investment banking fees that weren’t so transpar-
ent and may have led to a misalignment of interests.
My guess is that there is going to be more scrutiny
over these additional fees and costs.
Leverage and JointVentures
Let’s talk a bit about leverage in terms of ratios,
fixed versus floating, and maturity. Then, with
regard to joint ventures, we can talk a bit about
preferences and promotes. In these down mar-
kets, painful lessons are often replayed. What
have we learned and what are we doing differ-
entlythistime?Glenn,canyouwalkusthrough
leverage and JVs?
Lowenstein: On leverage: There is going to be less of
it, and it will be longer term. Probably one of the best
things that has come out of this is that there is industry-
cover2010fall

10. PREA Quarterly, Fall 2010 43
wide scrutiny on how managers made their money. It’s
one thing to have high returns; it is another thing to
get them from leverage and cap rate compression rather
than operations. In terms of joint ventures, industry
professionals today realize that any partnership arrange-
ment needs more stress testing. Previous market norms
will not cut it.
Jamie, as our representative from the consul-
tant space, what is your view on leverage and
joint ventures?
Shen: As far as leverage, my hope is that one of the
take-aways from this environment will be that when as-
sets are being priced to perfection, instead of maximiz-
ing leverage, we will see that as a point in time when
we should be minimizing leverage and protecting our
downside. We have seen what can happen and how we
can so quickly go outside of guidelines.
As far as joint ventures go, it seemed that people
had forgotten that there is risk with joint ventures.
When we went through this downturn, there was a re-
newed highlight that joint venture partner risk exists,
and you do have to be concerned about the partner’s
operations and going concern and whether or not the
partner can make capital calls. In some ways, I think
it was a good thing that we were reminded in this
downturn of all the risks that you need to address in
joint ventures. If an investment manager is doing a lot
of work through joint venture partners, there is going
to be more focus from the industry on whether the
manager has the capabilities to replace a joint venture
partner, whether the manager is putting in appropri-
ate safeguards in case that joint venture partner can-
not make the capital calls, and the way the manager
is underwriting the joint venture partner’s business.
There may be more of a focus on these items than
there has been in the last five years.
Thanks, Jamie. Keith?
Barket: First of all, I’d say leverage and fund guaran-
tees were the number one sin committed over the last
decade, and the rationale that managers used was that
leverage was cheap—too cheap—and therefore, you
should be on the other side of that trade. Academically,
that is probably correct, but it is kind of like going to Las
Vegas and saying my odds of winning on this wheel are
55%, so I’m going to bet everything. It doesn’t leave you
in a position to recover if you are wrong.
By“guarantees,”you mean what?
Barket: Fund-level guarantees of debt versus non-
recourse debt. I can get 50% nonrecourse debt, but
I can get 75% with a full guarantee. If you look at
the funds that have really lost a significant amount of
equity, most of those have fund-level guarantees that
brought them down.
Going forward, I don’t think there should be a dif-
ferent strategy with respect to leverage; the amount of
debt you use should be responsible and largely non-
recourse and non-crossed. Whether you fix or float
should be dictated by the length of your expected
holding period. Spreads are wide, but Treasuries are
unusually low right now. In our view, if you have a
longer-term hold, it is a pretty good time to fix rates,
even if spreads may tighten over time. It is pretty sim-
ple when it comes to the leverage side.
On joint ventures and club deals, I totally agree with
Jamie. I really hate doing club deals with other op-
portunity funds; and these are funds that are generally
well-staffed and in a position to make quick decisions. It
simply slows down your decision making and may lead
to conflicts. Funds may differ in their access to capital,
their incentives, their view on repositioning, etc., which
can lead to deadlocks and confusion. That is a signifi-
cant risk in club deals. In terms of joint ventures, there
are LPs who are in a good position to do joint ventures,
and if you look at what they pay their staff versus what
they would pay a manager, they can probably save
money in some cases. The key, though, is having a large
enough wallet to get the diversification you want and
having the appropriate size and quality of staff to make
it work. Some people, like Michigan, have been able to
do that over the years, but I don’t think there are a lot of
investors set up to successfully operate that way.
Jon, Keith made a nice segue to you. What is
your view?
Braeutigam: Keith is too kind. Leverage ratios are
coming down, but when we have low interest rates—
call me cynical—people are going to take the leverage
if they can get it. I think we are in an area where we are
all saying we like low leverage, but when somebody
Leverage ratios are
coming down, but
when we have low
interest rates—call
me cynical—people
are going to take the
leverage if they
can get it. ... when
somebody gives us
free money, some-
how the market will
always take that.
Jon Braeutigam

11. 44 PREA Quarterly, Fall 2010
cover2010fall
gives us free money, somehow the market will always
take that. I think the Fed is trying to re-inflate asset
prices to some degree, and it is going to be success-
ful at it. Keith makes a great point about how you use
leverage. Is it on a property-by-property basis? Are all
these properties cross-collateralized? If you have a risky
asset and it blows up, does it blow up your good assets?
Is leverage on the fund? So all these areas have to be
looked at. We prefer modest leverage, in the 40% range
typically. Some of our assets don’t have any leverage,
some of them have a little bit higher, but we try to target
above 40%; that way, if bad times come, we think we
can survive. In fact, that has proven to be the case with
the current downturn.
With regard to JVs, the industry will always have joint
ventures. There are a lot of risks with joint ventures, but
what you are trying to get at is a deal pipeline where you
get expertise in sourcing and running property. Many
times, that is at the local level. As an investor, I would
ask our joint venture partners if they are well-capital-
ized. If they are not well-capitalized, we might still do
the deal, but we know that is an additional risk. How
long have they been doing joint ventures? Do they have
experienced staff? Have they retained that staff over the
years? I think Marc has pointed out that there has been a
tiering; I think you will see a tiering on the joint venture
side too. A lot of companies have just gone away, but
other companies have proven themselves by managing
through this, and they will have the advantage.
Pat, your view please.
Halter:Peoplehavecoveredthisquitewell,butonething
this discussion really highlights is that as a real estate in-
vestmentmanagementorganization,youaregoingtohave
to really demonstrate this duo excellence, not only under-
standing and managing the assets but also executing these
leveraged strategies on the liability side of the balance
sheet. That entails achieving the most favorable costs of
debt capital available and being able to use your relation-
ship with lenders to achieve the most flexibility. What I
mean by that is that loan assumptions, collateral assump-
tions, collateral substitution rights can all be impediments
to execute sale strategies. You want to make sure you ne-
gotiate and manage ways to reduce those impediments.
We have a general philosophy of asset liability matching.
We try to take the average life and duration characteristics
of the debt and hope they are generally consistent with av-
erage property lease maturities of the assets. We like to use
fixed-rate debt, unless it is a situation where we are near a
sale and planning to allow for a better matching of the as-
setsandtheliabilities.ToJon’spoint,youdowanttoavoid,
whenever possible, cross-collateralization, cross defaulting
of loans, in order to maximize the flexibility of that sort
of bet and put option with nonrecourse mortgage loans,
meaning if you have a bad asset, it doesn’t take down all
the good assets, also as Jon mentioned. This is obviously
not as critical now with my earlier points, as we are in
a sort of a bottom of the market cycle, and we’re going
to be seeing low-leverage strategies, but I think it is very
important from a risk management perspective to apply
that sort of mind-set.
Relative to joint ventures, Joe, obviously, post the
global financial crisis, the pendulum has swung back to
the capital partner’s favor. Administration, the monitor-
ing of operating partners will increase and will become
more rigorous. There will be more established proce-
dures to follow. The oversight governance of the joint
venture is going to become more formalized, and the
level of discretion definitely has been narrowed. There
will be much more documentation and clarity as to how
dispute resolutions, or buy-sell provisions, work. One
of the things that people learned is there is a lot of nego-
tiation just as to how those things worked.
A lot of ambiguity in the legal documents that
sometimes comes out in practice, right?
Halter: I agree.
Marc?
Weidner: The typical metric that has been used in the
past—loan to value, floating or fixed interest rates, and
debt maturity—has not been appropriate because it is
not enough. It was not enough to really understand the
true debt risk exposure and the impact that debt can
have on these assets and how they can drive the value.
The devil is in the detail, and the reality of the leverage is
beyond these starting points. In the past, leveraged anal-
ysis was really checking the box—Was it fixed? Was it
floating? What’s the maturity? What’s the LTV? Today, we
really need to peel back the onion and go much deeper
into the analysis because seemingly low-leveraged debt
can be extremely toxic if it’s associated with an asset that

12. PREA Quarterly, Fall 2010 45
does not produce long-term stable cash flows or where
there is high volatility related to the future prospects of
the assets. We pay a lot of attention to really understand-
ing the details of the loan documents, including all the
covenants, whether the debt is recourse and, if yes, re-
course to what, all of which has had far-reaching devas-
tating effects on some real estate funds.
Regarding the leverage level in today’s environment, we
believe the overall leverage level is only the starting point
of the analysis. We strongly believe that we need to differ-
entiate between the type of assets that are subject to lever-
age. So you cannot put in the same basket a 20-year lease
of a very good tenant credit with upward revision only
and compare the leveraged level of that asset to a construc-
tion loan. Today, we are seeing that the traditional debt
structure is back, as opposed to the exotic structures we
experienced in the crazy years between 2005 and 2008.
New debt is currently slowly becoming available at
reasonable LTV ratios with amortization, interest pay-
ments, and tight covenants, none of which was present
in some debt structures that are currently the most toxic.
A high level of leverage is basically not available today
for new loans. A lot of portfolios have very high lever-
age levels because the equity portion has been written
down, not necessarily because they had a lot of leverage
initially. These portfolios are obviously at risk and will
need new equity injections.
Regarding fixed versus floating rates, it has always been
our preference to focus on the real estate risks and the
value that is created by the real estate as opposed to trying
to take a directional bet on interest rates. Our preference
is therefore to get exposure to transactions with fixed rates,
especially in a low-rate environment like today.
Investment Management
Business Models
OK, let’s have our first comments on business
models, changing resources, and the like
from Keith.
Barket: I think what is happening in the industry, particu-
larly the opportunistic and value-add industry, is that we are
evolving. Marc said this earlier, that we went through a pe-
riod of an up market, where it was hard to distinguish good
managersfromweakermanagers.Theopportunisticindustry
wasn’treallybornuntiltheearly1990s,sotherehasn’tbeena
significantdownmarketuntilrecently.Thereweremorethan
600fundsintheU.S.Ifyoulookatotherindustries,eventhe
core real estate market, fewer managers stand out and domi-
nate over time due to their proven long-term track records. It
is the same in the venture capital industry, which has been
around for 40 years now, and the hedge fund and private eq-
uitybusiness.Thisisanevolutionthatisgoodforthebusiness.
People are searching for an answer and wondering if it is fees,
if it is the structure, if it is the investment banking model. A
big part of the answer is that we needed this evolution to sim-
ply weed out the weaker players.
Glenn?
Lowenstein: I’d say there are two big things that I see.
One is that people will spend time annually remeasur-
ing incentives rather than looking at them just at the
beginning. There will be an annual assessment of what
everybody’s position is in the deal and what everybody’s
incentive is. The second thing that will happen is that
there will be a bigger focus on what risks are being tak-
en and how returns are being generated. Deconstruc-
tion of returns, not just the absolute level of returns,
will become increasingly important. I think an industry
standard will be developed.
Thank you, Glenn. Jon?
Braeutigam: I will go with the investor side first.
Investors are going to have to do a little bit more
with less. Most investors—and I’m talking about
the public fund world and maybe endowments and
such—will be loath to increase staff right now. They
will be either at a head count freeze or a slight staff
reduction, so you will see pressure for them to do
more with less. That is going to be the investor’s
business model for the next few years for the pub-
lic funds. From the 50,000-foot level, the advisor’s
business model is going to change. You’re going to
see a lot of advisors go, some come, and some get
stronger. From the 2007 peak, my guess is that em-
ployment is down probably 20% across the whole
industry. At the peak, about 10% of that was fat—
you didn’t need those employees anyway. I would
guess that about 10% of that will be hired back in
the next few years as people put money to work in
real estate. Funds will attract capital, and the inves-
tor GPs will have to have staffing, so they will be in
a slight hiring mode.
The opportunistic
industry wasn’t really
born until the early
1990s, so there hasn’t
been a significant
down market until
recently. ... If you look
at other industries,
even the core real
estate market, fewer
managers stand out
and dominate over
time due to their
proven long-term
track records.
Keith Barket

13. 46 PREA Quarterly, Fall 2010
cover2010fall
As someone who is trying to place students
in jobs, I’m thankful to hear that, Jon. Pat,
how about you?
Halter: In this global financial crisis, a lot of us missed
the big picture. One of the things we have been do-
ing is really strengthening our firm-level macroeco-
nomic views and trying to get more of those linkages
and views into the various asset classes that we manage
from a global asset management perspective. Develop-
ing more robust quantitative and risk-modeling tools is
a big part of that also, as is redoubling our commitment
to risk management; we’ve created some dedicated risk
management roles within the organization and filled
those roles with top talent. That is very important going
forward. From a personnel perspective, engaging talent
is really important. The market pressures, the business
changes already discussed will unquestionably create
challenges around retaining and engaging key talent
going forward. That is really mission critical number
one for many organizations.
Marc?
Weidner: It’s been a challenging time for all of us,
but we have been very fortunate at Franklin Temple-
ton. During the crisis, we have been able not only
to maintain the level of resources dedicated to our
real estate group but also to increase it, and we think
that’s very much appropriate given the complexities
of today’s markets. We feel that going forward, there
will be very attractive opportunities, but they are not
going to be readily accessible. So a lot of due dili-
gence, a lot of work needs to be done, and the gems
are going to be hidden deep in the river; we will need
to turn each stone in order to discover them. This is
why we have increased the level of our resources.
Within the last 24 months, in the advisor business
model universe, what we are seeing is likely consolida-
tion of large players that have been able to integrate the
different expertise needed by their clients. It has been
a very difficult environment for start-ups and smaller
investment managers. A couple of them might be suc-
cessful, but the environment was certainly more con-
ducive to smaller, niche players in the past.
The change we are seeing is that our clients are un-
derstandably asking more questions, need more face
time, and want more information in real time. There
has been an overall increase in attention and desire and
need for information. Better projection, faster turn-
around, deeper analysis, accurate real-time information
is a trend we believe will continue. From a deal point
of view, doing a transaction takes more time, requires
more resources and certainly more analysis than ever
before, and we think this is going to continue in the
future, which is why larger, more experienced groups
may have a competitive advantage in screening all the
opportunities on an ongoing basis.
Thank you. And Jamie?
Shen: It is a due diligence challenge for us. We have
been talking about how to retool areas of our due dili-
gence questionnaire to account for some of the new is-
sues that are important to uncover when you assess or-
ganizations, staffing, and future resources. On the other
side of it, there is an underestimation of how much it
takes in monitoring these more complex investment
programs. One thing we are looking at very carefully
is that when we recommend these strategies and move
to a more complex program, is the staffing level of the
client appropriate? Can the strategies be supported by
the staff, and can the client get the resources it needs
to implement such a program? If you have fewer re-
sources on the investor or plan sponsor side, you might
not undertake a complex program or you might out-
source some of the monitoring that goes along with
more complex programs.
Thank you, everybody, for your time. It was
an excellent and interesting discussion.
Keith Barket is Senior Managing Director of Angelo, Gordon
& Co.; Jon Braeutigam is CIO, Director of Bureau of
Investments for the Michigan Department of Treasury; Pat
Halter is Executive Director for Principal Global Investors
and Chief Executive Officer for the firm’s dedicated real es-
tate group, Principal Real Estate Investors; Glenn Lowenstein
is a Principal of the Lionstone Group; Joe Pagliari is Clinical
Professor of Real Estate at the University of Chicago Booth
School of Business; Jamie Shen is Senior Vice President at
Callan Associates, Inc.; Marc Weidner is Managing Director
of Franklin Templeton Real Estate Advisors.
In this global fi-
nancial crisis, a lot
of us missed the
big picture. One of
the things we have
been doing is really
strengthening our
firm-level macro-
economic views and
trying to get more of
those linkages and
views into the various
asset classes that we
manage. ... Devel-
oping more robust
quantitative and
risk-modeling tools
is a big part of that ...,
as is redoubling our
commitment to risk
management.
Pat Halter