Real Estate

Transcript

Investors with allocations to just one alternative investment asset class are most likely to be invested in real estate.  Real estate is much more widely held by individual investors than commodities, infrastructure, private equity, or hedge funds.
Investors can allocate to real estate debt or real estate equity. As consumers and homeowners, we’re relatively familiar with the difference between real estate debt and equity.

Real estate equity investors purchase real estate properties to earn lease income. Some investors purchase the properties and own them directly, while others invest in funds that buy and operate buildings.

Real estate debt investors lend money against real estate properties.  For long-term financing, investors can originate 15-to-30-year residential mortgages or purchase mortgage-backed securities. Investors earn income from the loans and take a security interest in the property. Mortgage-backed securities pool hundreds of loans together into a bond that a government agency might guarantee, providing geographical and borrower diversification to investors.

Private credit and asset-backed lending funds make shorter-term loans, often 3- to 5-years in maturity.  Opportunistic real estate investors often need shorter-term capital, borrowing money for up to two years, which fits nicely with the private credit fund structure.  Real estate developers borrow through bridge loans, construction loans, or redevelopment loans, which are repaid when the property is sold or refinanced to a long-term mortgage once the property construction or redevelopment is complete.

When you invest in real estate as a direct investor, you could buy and operate the buildings, which requires a substantial amount of capital and operating skill. When you’re actually buying a building, you have to buy the entire house, the entire apartment building, the entire office building, and you need to operate it as well. Investors who can find tenants and lease it to them can earn a nice cash flow for the property. But of course, they’re also responsible for the maintenance and the property taxes and all of the issues that go with owning and operating a building. The upside of a direct investment in real estate and actually buying the building is that you could have a very long holding period. Investors who buy this as an individual investor, could benefit from the depreciation as well as the step up in basis, in not paying those capital gains if you pass it along to your heirs after they pass. A direct investor in real estate, doesn’t have to pay any asset management fees, but of course, you might choose to have a property manager to take care of the leasing and maintenance issues.

In addition to actually buying the properties directly, you could invest through a fund management solution for your real estate investment needs. You could go into the public market or the private market. In the public market, we typically think of REITs or real estate investment trusts. Investing in publicly traded REITs is highly liquid, as you’re able to buy and sell any moment of any day, when the stock market is open. There’s daily valuations, and you’re going to earn a regular dividend income. REITs are highly regulated by the SEC and subject to public disclosures, but the downside is that publicly traded REITs are volatile, perhaps being influenced by stock market volatility. If the stock market is having a particularly bad day, the price of a REIT might decline, even though it’s a real estate investment and not necessarily a stock market investment. There is some crossover volatility between the equity market and the public real estate market, but you do have very substantial liquidity when you’re investing in publicly traded REITs.

Investors could also allocate to real estate through a private equity fund or a private or a non-traded REIT. These fund structures have much less liquidity and might have larger minimum investment and require you to be an accredited investor.  But these private investments in real estate don’t appear to be volatile because they’re going to be priced often on a quarterly basis. You’re getting a quarterly net asset value, just four times a year. That NAV is based on appraisals, not necessarily on direct market pricing. So these private real estate funds are going to be less volatile and less liquid, but that doesn’t necessarily mean they are less risky than public REITs. We’re probably underestimating the investment risk of just looking at private real estate and probably overestimating the risk of investing in private real estate through REITs.

It’s important to note that investors in a private placement such as a private equity fund or a non-traded REIT, are going to be subject to less scrutiny by the SEC if they’re organized under the private placement exemption, there might be less transparency and less protections of the SEC. Investors need to understand how the fund is regulated. Is it organized as a private placement, is registered under the ‘33 Act or is it registered under the ‘40 Act.

In real estate, we talk about core property types, multifamily and apartment buildings, retail, office and industrial with warehouses and logistics. These are the core property types. The lower-risk real estate investors will focus on these core property types.

There are a wide variety of ways you could invest in real estate, including non-core property types, such as self-storage, senior and student housing, hotels, data centers, healthcare and life sciences, single-family housing, land, and mixed-use developments.

It’s fairly compelling when we look at the numbers to add real estate into an asset allocation. Over the last 20 years, the PitchBook Private Real Estate index had a return and a risk similar to that of stocks. Over 20 years, stocks had a total return of 11%. While real estate over 20 years had a total return of almost 9%. The volatility and drawdowns of real estate and stocks are similar. But if we look at the correlation statistics. The correlation between real estate and stocks is just 0.3, and both stocks and bonds have a negative correlation to inflation, while real estate has had a positive correlation to inflation. This is the key. We have a low correlation between real estate returns and stock returns. The long-term returns on real estate and stocks are relatively similar, but there’s a very different exposure of real estate relative to interest rates and inflation.

The returns of stocks and real estate are similar over the 20-year period. Volatility is similar, but there’s a low correlation of returns between the two. Mixing stocks together with bonds and real estate in our portfolio is going to be positive for the risk-adjusted returns of our portfolio especially during times of rising rates and rising inflation.

When inflation is very high, almost 5% in the highest quartile of inflation experienced over the last 20 years, stocks have averaged returns of less than 1% when inflation is at its highest, but the average quarterly return to real estate is almost 3% per quarter during those times of highest inflation.

When inflation is above average, we see that real estate outperformed stocks, and when inflation is below average, stocks have historically outperformed real estate.