By Thomas Hoops
With U.S. equity markets at historical highs and many bonds offering minuscule returns, where can high-net-worth investors turn for income, particularly as so many move into retirement?
Investing in U.S and global real estate previously meant investing in the actual properties—a prospect mostly available to institutional and accredited investors. Today, the asset class is becoming more broadly available to high net worth individuals through new private equity funds. While requiring a long-term commitment from investors, these funds seek to capitalize on favorable real estate market conditions, with some featuring monthly or quarterly liquidity.
Real estate has proven to be a successful asset class, with a 9.7 percent 20-year annualized total return as of the second quarter 2017 (based on data from the NCREIF Property Index, or NPI). That this encompasses the global financial crisis and subsequent real estate slump makes the overall track record even more impressive.
There are five primary reasons to invest in private equity real estate funds:
- Attractive Risk-Adjusted Returns. Offering risk/return profiles that are usually between equities and fixed income, real estate can also offer attractive risk-adjusted returns. Lower volatility has often contributed to this strong historical performance associated with this asset class.
- High Income Potential, with Inflation Hedges. Interest rates are rising in the U.S. and elsewhere. Real estate funds can be comprised of high-quality, high-value properties that are well-managed and produce attractive income in the form of rents. Many professionally-managed leases allow property owners to raise rents enough to at least keep pace with inflation. Real estate funds have the potential to provide quality annual dividend income for investors.
- Diversification in Mixed-Asset Portfolios. Real estate generally has exhibited very low or even negative correlations between stocks and bonds. Many large core real estate funds are also diversified by geography and property types. These features can help investors manage portfolio volatility.
- Deeper, More Liquid Markets. Institutional investors have almost tripled allocations to commercial real estate, from 3.7 percent in 1990 to 9.9 percent by 2016, mostly in semi-liquid, open-end core funds. This appetite has helped increase the market value of the NPI, the leading measure of property-level returns, by 16 times: to $525 billion, from $33 billion. The number of constituent properties has grown to more than 7,300, from less than 1,700. The investible universe continues to expand.
- Favorable Fundamentals. Economic, employment and population growth help drive real estate investment. Fundamentals of supply and demand, and movements of capital markets, are the primary drivers of total returns. Regulatory and market constraints on construction financing have depressed development activity in recent years, but with key economic indicators improving, most U.S. real estate markets are benefiting from stronger demand than supply. This helps to create enhanced opportunities for investors.
This is not an asset class individual investors should purchase blindly. Detailed knowledge of the specific properties that underly each fund, the market conditions in each area, and expertise with the financing issues particular to real estate transactions are imperative to assessing a fund’s true value and the likelihood of future success. There is a large disparity—historically and recently—between fund manager performance in the top and bottom quartiles. We recommend finding proven active managers with substantial core real estate experience across multiple market cycles. The top managers in this growing field have very often earned their fees, and then some.
The key driver in real estate investment promises to continue to be income generation. High net worth investors can now take advantage of the favorable income and return potential core real estate funds often offer. Diversification away from stocks and bonds and hedging against inflation are added benefits. As the asset management industry innovates and introduces more products to meet client demand, high-quality real estate investment options should only grow.
The U.S. has a growing economy and the largest liquid real estate market in the world, with good depth yet to be fully plumbed. Europe and Asia are rebounding, creating more demand. So long as economies grow, people will crave more and better residences and commercial spaces.
All it takes to be bullish on private equity real estate funds is common sense, a sharp eye – and a good advisor.
Tom Hoops is Head of Business Development of Legg Mason.