The pitfalls of private real-estate investing

The pitfalls of private real-estate investing

The pitfalls of private real-estate investing

Given the historic lows in interest rates and the current volatility in the equity and fixed-income public markets, it’s no surprise to see some investors looking afield for ways to diversify their portfolio. But those considering exposure to the private real-estate sector might want to consider the decision carefully.

“Owning real estate can provide many benefits to a portfolio, not the least of which is diversification,” wrote Martin Pelletier of Trivest Wealth Counsel in the Financial Post. “[But] the illiquidity of [private real-estate investments] and what at times can be a lack of transparency can make it more difficult to measure those benefits.”

He noted that real estate is sometimes promoted as a low-volatility and low-correlation asset class. But work done by Abraham Park, an associate professor of finance at Pepperdine University’s Graziadio School of Business and Management, flies in the face of such claims. In particular, Park criticized the practice of “appraisal smoothing,” which artificially depresses the variance measurement within real estate rates of return series computed from unadjusted appraisal data.

“This type of smoothed series underestimates the riskiness of the real estate asset class and also distorts its correlations with the rates of returns of other assets,” Park wrote in the Graziado Business Review.

That means investors in private real estate can determine the real value of an asset only by trying to liquidate their positions. But given the fact that most investments are locked in and not available for redemption for at least five years, that can prove challenging.

Pelletier also cited a study by Cambridge Associates, which compared the returns of 942 private-equity real-estate funds with those of publicly listed REITs. Looking at a 25-year period ended in Q1 2017, the study found that REITs delivered 11.1% in annualized returns, while private real-estate funds returned 7.2%.

“Interestingly, private equity real estate funds underperformed despite deploying an average leverage of 51 to 64 per cent compared to only 36 to 47 per cent for REITs,” Pelletier said.

He clarified that despite the evidence against private real estate, large institutions and pension plans have had moderate success in the sector. However, such large investors have the luxury of a substantial time horizon and annual cash inflows, as well as teams to conduct thorough due diligence on the amount and type of leverage deployed, geographical diversity of portfolio holdings, the type of structure in which the assets are held, and other characteristics of private real-estate fund managers.

But institutional investors may be shifting away from private equity firms, which are piling up a record amount of dry powder, and turning to liquid funds that can put their money to work faster.

“Finally, if you are considering private real estate, don’t go to crazy on the weighting,” he said, as it could reduce the opportunity to diversify into other market segments such as small- and mid-cap equities, emerging markets, and even commodities.

 

Follow WP on Facebook, LinkedIn and Twitter