Advisors Should Consider Alternatives to Publicly Traded REITs

Commentary May 25, 2017 at 05:04 PM
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U.S. commercial real estate is a $13 trillion market, a meaningful subset of a capital markets universe that includes $35 trillion in public fixed income securities and $25 trillion in public equities.

Despite the size of the market and importance to the U.S. economy, most individual investors have limited investments in real estate. Individual investors often think of their homes as investments, but homes used as a personal residence are more "use" asset than investment asset. Advisors invest in publicly traded REITs to take advantage of attractive yields relative to stocks, ongoing liquidity and simple tax treatment. However, given limitations associated with the public REIT structure, advisors should consider a wider array of options for clients who have the ability and willingness to invest in less-liquid real estate alternatives.

Private REITs and other forms of private real estate investment may offer an attractive alternative to publicly traded REITs, either to supplement core positions in publicly traded REITs or on a stand-alone basis. Private real estate investment offers some important benefits, including:

  • Broad opportunity set: The universe of publicly traded REITs is less than $1 trillion, representing a narrow portion of the $13 trillion real estate market. The expanded investment universe provides the potential for higher returns and greater diversification.
  • Portfolio diversification: Publicly traded REITs were once thought to be an effective source of diversification, trading with reasonably low correlations to stocks. However, as the REIT market has grown in size and trading volume, correlations between publicly traded REITs and stocks have risen. Consequently, publicly traded REITs are now much less effective as a source of diversification. Price changes for private REITs are tied more directly to real estate fundamentals, making private REITs less correlated with stocks and a more effective source of diversification.
  • Income growth and inflation protection: Lease agreements may provide consistent income through market cycles, and contractual rent increases create inflation protection.
  • Favorable tax treatment: Pass-through of depreciation may provide a partial sheltering of distributions from current taxation.

Private real estate investments faced significant criticism in recent years, as high-profile scandals in the nontraded REIT industry drew press and regulatory attention. Some nontraded REITs were big losers, sold to yield-hungry investors who were unaware of high upfront costs, poor governance, misleading disclosure, and use of leverage or return of capital to boost distribution yields.

Most of the highest profile private REITs have better alignment between REIT managers and investors. JPMorgan, Blackstone, Broadstone, Jones Lang LaSalle and TIAA are among the widely respected firms offering private real estate products with reasonable investment costs, capable management teams and shareholder-friendly governance structures.

In selecting a private real estate investment, advisors should:

Determine the role of private real estate in the portfolio.

Advisors using private real estate as a stand-alone investment should consider approaches that are diversified across property types and geographic regions. Property types typically included in diversified commercial real estate offering include apartments, industrial, retail and office. 

Advisors using private real estate in combination with other real estate investments can consider a more opportunistic approach, with investments in a single property type or region among the potential options. Larger managers provide an all-inclusive approach, while specialist managers may focus on a single segment. 

Time horizon is another factor to consider. Clients with minimal liquidity needs can lock up their investments for longer periods of time, potentially boosting their long-term returns.

Select the risk/return profile that is appropriate for the client.

Core real estate strategies seek predictable income, moderate capital appreciation and low leverage. Core strategies tend to be the least risky and most liquid, and typically don't employ a lot of leverage.

Value-added real estate strategies focus on properties that require some degree of improvement, with the manager providing physical or operational improvements to increase property value. Value-added strategies are moderate to high-risk, and typically involve more leverage than core strategies. Successful value-added strategies offer higher potential return than core strategies.

Opportunistic strategies are turnaround situations involving significant enhancement of properties that are distressed or in early stages of development. Opportunistic strategies offer high potential returns, but significant risk.

Evaluate the quality of the management team.

A real estate investment is only as good as the management team responsible for acquiring and managing the portfolio of properties. Advisors should complete thorough due diligence to evaluate the depth, experience and expertise of the real estate team.

Management teams include research analysts, acquisition officers and financial analysts. Research analysts provide insight into the national and regional macroeconomic environment, property trends and considerations among different property sectors. Acquisition officers focus on identifying suitable properties, and determining appropriate valuations for property acquisitions and dispositions. Financial analysts also play a crucial role, particularly in evaluating lease agreements and assessing the creditworthiness of prospective tenants.

Understand the relevant details of the product offering.

Some offerings are designed for accredited investors, others for qualified purchasers. Minimum investment amounts vary, though product minimums are becoming increasingly accessible for investors who have a fee-based relationship with an advisor.

Investor redemptions are typically limited to a few specific windows during the year, and there are limitations to how much of the portfolio can be redeemed at one time. In a "rush for the exits" there is a risk that the investor will not be able to liquidate as planned.

There are a wide variety of investment expenses associated with private real estate, including placement fees, asset management fees and performance fees, so understanding the fee structure is an important part of the due diligence process.

Given the lack of a public market for real estate, the valuation methodology and process should be another distinct focus for due diligence.

There are risks that could jeopardize the multiyear bull market in real estate. The growth of online shopping is an existential threat for many brick-and-mortar retailers, and store closures are a rising threat for retail malls. Higher quality malls and shopping centers anchored by grocery stores are weathering the downturn in retail more effectively than second- and third-tier mall properties, but pressures on retailers may spread as Amazon-fueled disruption continues.

Rising interest rates are another risk. However, many real estate investors assert that during economic expansions, rising rents overcome the impact of rising rates. When rate hikes are attributable to a strong economy, job growth and rising rents tend to be more significant positive influences on valuation. The environment most likely to jeopardize the outlook for real estate is one in which interest rates are rising at the same time as economic activity is slowing and capital market liquidity is tight.

Despite the risks, U.S. economic growth provides a positive backdrop for real estate, and supply and demand is balanced in most property sectors. Advisors should consider a core allocation to real estate, and examine opportunities beyond publicly traded REITs for their investment allocation.

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