The Hunt for Yield: Tackling Misconceptions of PE Real Estate

With equities hitting all-time highs and Federal Reserve stimulus having limited effect on yields, advisors are turning to riskier assets as they become more desperate in their hunt for income.

There are indications demand is continuing to grow for private equity real estate, but advisors looking to diversify portfolios for high-net-worth and institutional clients should not be enticed by popularity alone. They should not be overconfident about real estate's resilience as a hard asset — nor should they be cowed by PE's old-guard image.

PE real estate is not for every client. It's best reserved for the advisor who can appreciate the strengths and weaknesses of the asset class, and understand how it interplays with portfolios in varying market environments.

PE Real Estate Is Not a Quick, Easy Investment

Some advisors are under the mistaken impression that investing in PE real estate is as simple as handing over a few million dollars to a generic fund manager who has targeted a popular Manhattan condo complex. Then, when investors are happy with their returns, they can pull out of the fund and move on.

The reality is that these are not liquid investments. With typical hold times for PE real estate funds ranging from five to seven years, investors must have liquidity from other sources. But those who give up that liquidity are positioned to benefit from an illiquidity premium.

Investors may add recession-resilient assets aimed at lowering risks and increasing returns. But like any sector, real estate expands and contracts, outperforming equities in some environments and underperforming them in others.

Self­-storage units that meet certain criteria concerning geography, expense ratios and market size are among the highest-returning, lowest-risk sector of the real estate asset class. They can appreciate in value as the economics of their counties develop or as they undergo technological upgrades, financial realignment or consolidation.

Fund Managers Shouldn't Be Lumped Into One Category

These PE real estate hold times require fund managers to have a well-honed strategy, a nuanced understanding of their subsector, and the experience and expertise to execute a vision across a whole market cycle in order to generate healthy returns. The idea is not to chase a tech stock at a 52-week high, but rather to filter into complex segments within the commercial real estate space that demand specialized knowledge as part of a long-term investment strategy. They must demonstrate breadth, fully appreciate risk, and ensure their methodology works on a broad scale. These funds also have higher due diligence standards that smaller, less experienced managers sometimes have trouble meeting.

Payouts Not Subjected to Market Whims

As a hard asset, real estate has the potential to act as a volatility hedge. Barring a major disaster, property will continue to exist even if currency or other traditional investments lose their value. As the 2008 financial crisis demonstrated, commercial real estate can return to its original value and continue to grow after a loss. The focus on consistent returns in various market environments requires a different mindset for investors whose financial decisions have been dictated by fear and greed. Quarterly payouts are not subjected to the whims of the market, nor should they be borrowed by the asset manager just to be paid.

PE Real Estate Is Not a REIT

PE real estate allows HNW investors and institutions like endowments and pension funds to invest in recession-resilient property assets with a diversified approach to property ownership. Real estate investment trusts, which resemble mutual funds, are highly liquid securities that invest in real estate through property or mortgages. Most are traded on major stock exchanges.

One of the downfalls of REITs, especially publicly traded ones, is that they price every day, often mirroring the movements of equities. The distinction is important because some use the performance of REITs as an indicator of the likely performance of PE real estate funds — incorrectly assuming that if REITs have ups and downs, PE real estate must too. While REITs were once the best performing investments delivering annualized returns, they lack a downside focus, and their shares are underappreciating. As an example, year-to-date, self-storage REITs are currently down 17%. REITs’ liquidity also subjects them to selling, forcing redemptions at inopportune times for the manager, challenging the investment process.

REITs have a number of advantages too, such as a tendency to be less volatile than traditional equities. They are also rarely taxed at the trust level, increasing their potential to offer higher yields than stocks once passed on to holders. Some advocate using one asset class to balance the other in a portfolio, including both REITs and PE real estate to spread out the risk and increase the potential of risk-adjusted returns.

A Changing Story

Real estate poses a natural storyline for investors — an upscale shopping mall, a new rental apartment complex, a dream home, people and neighborhoods as the variables that determine value. Advisors might be tempted to sell less financially savvy investors on that story. But, as we learned from the foreclosures that resulted from the 2008 housing crisis, the emotions that accompany homeownership can sometimes be blinding, obscuring our view of the metrics and due diligence needed to make sound investment decisions.

PE real estate requires the same level of scrutiny as publicly traded securities, as well as a deeper understanding of financials, the social landscape and macroeconomics, from the industry level down to the various asset classes and geographies. Today's success story might just be a mom-and-pop self-storage unit out in middle America reaping the benefits of a new online auto-pay system, whose story is compounding all across the U.S. to seek the creation of a new kind of wealth. The advisor who grasps that, along with all the complexities of the asset class, will be the one best positioned to tell the story to investors.

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