One of the leading areas of the alternative investment world is real estate. In fact, according to MSCI, the value of professionally managed real estate investments in 2019 was at least $9.6 trillion. They note that the U.S. continues to be the largest market, followed by Japan and the United Kingdom. In both residential and commercial markets, alternative investors are a growing force, seeking out both capital gains as well as reliable streams of income.
Key Strategies
Real estate comes in many shapes and sizes within the alternative asset class. For one thing, there is some overlap with what might be termed ‘traditional’ assets. That’s because investors have access in public equity markets to so-called Real Estate Investment Trusts. The way to think about these vehicles is that they’re alternative investments that happen to be traded on major exchanges. Importantly, there are also REITs that exist in private markets, and are only available to accredited investors.
REITS can be thought of a somewhat akin to mutual funds but for real estate. Instead of a managing a portfolio of stocks, though, a Real Estate Investment Trust “owns, operates, or finances income-generating” property instead. And as Investopedia observes, there really is a multitude of ways in which they can do business: REITS can “invest in most real estate property types, including apartment buildings, cell towers, data centers, hotels, medical facilities, offices, retail centers, and warehouses.”
Broadly speaking there are two types of REITs: Equity REITs and Mortgage REITs. Equity REITs own part or all of the real estate in which they invest. By contrast, Mortgage REITs are effectively lenders rather than owners or operators. They help finance real estate and earn an interest rate in the process. There are also some vehicles that can be considered Hybrid REITs, in the sense that they have stakes on both the equity and mortgage side of real estate investing.
Another way for investors to get exposure to real estate is via private equity funds. Private equity funds focused on real estate are pooled structures that raise money from a group of (typically accredited) investors. These funds can then be combined with money borrowed from banks to invest in particular projects or loans.
The National Commercial Real Estate Development Association identifies 5 types of real estate PE funds:
- Core: These are the most conservative funds, with a lower risk and lower return profile. They tend to sport returns of 6-8%, use little or no leverage, and own “well-occupied, stable, high-quality assets in primary markets and locations.”
- Core-Plus: These PE funds own high-quality estate in secondary markets, target higher returns than Core funds (8-12%), and use some leverage (up to 50%) to enhance returns.
- Value-Add: These funds “contain assets improved via re-leasing, operational efficiencies and/or redevelopment.” Leverage is higher than Core-Plus funds (up to 70%), as are targeted returns (11-15%).
- Opportunity: Of all the real estate PE funds focused on the equity side, these are the ones with the highest risk-reward profile. Such ventures look for capital appreciation opportunities with land or buildings that haven’t been well-developed or have low rates of occupancy. This can involve redeveloping or repositioning a property. Target returns for these funds are above 15%.
- Distressed Debt/Mezzanine: Unlike the previous 4 fund types, these ones are debt investors. They own the debt of properties that are high risk or in some sort of financial difficulty. Such funds offer returns of 8-12%, and can become equity investors in the case of a default.
The Investment Case for Real Estate Investing
There’s an adage you may have heard: “All real estate is local.” In other words, real estate is not a unform market. A multifamily residential property in Seattle may seem to have little in common with a commercial property in Japan. That said, there are some general factors that lead investors to commit capital towards the sector:
- Enhanced returns: On both the debt and equity side, real estate investments may offer higher returns than those found in public equities or liquid fixed-income markets. Many investors have gravitated to real estate (both residential and commercial) in an era where interest rates are very low and government/corporate bonds offer yields that often fail to keep pace with the rate of inflation
- Diversification: Real estate may be an uncorrelated asset class, meaning that it is not tethered to the swings of global equity markets, and thus helps to dampen a portfolio’s volatility.
- Inflation hedge: As a hard asset (as opposed to a financial asset), this asset class may offer some protection against inflationary pressures.
What are the Risks?
As with any sector, there are risks to be cognizant of when it comes to real estate investing. Here are some of the key ones:
- Market risk: Real estate is a cyclical industry that can be prone to booms and busts. There are opportunities no matter where a market is in the cycle, but it’s crucial to not be overexposed when it gets too frothy.
- Leverage: As detailed above, many real estate investing strategies rely on the use of leverage to enhance returns. This, in short, makes the good times better but can also make the bad times worse. Too much leverage at the wrong time can cause a fund to experience significant financial issues.
- Liquidity: As with hedge funds, liquidity can be an issue in private real estate funds given the lengthy lock-up periods and limited abilities to redeem units.
Common Fee Structures
There are different fee structures for real estate investments depending on the vehicle in question. To use one example from the world of REITs, investors may pay a sales commission to a broker (3.5%), a management fee (1.25%), a servicing fee (0.85%), as well as a performance fee above a certain hurdle (12.5% on returns above 5%).
For private equity funds, on the other hand, their fees are similar in nature to those of hedge funds. They usually have a management fee plus performance fee model, where the fund manager earns between 1-2% based on assets under management, plus a performance fee that can be 20% or more. In addition to these fees, there can also be other charges specific to real estate investing, such as acquisition and property management expenses.
What to Look for in a Good Manager
If you’re thinking about investing in a real estate fund, you’ll want to ensure that a manager has both the track record and expertise to deliver. Related to the latter point, it’s important to confirm that the manager has a sufficient team in place for the acquisitions and developments they seek to do. Real estate is a labor-intensive field and requires substantial bench strength to do well.
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