Understanding private real estate

Commercial real estate (or CRE) is the third-largest asset class in the US behind stocks and bonds, and the lion’s share of this $21T market is available exclusively through private investments (see chart).

While there are many ways to invest in real estate, this article focuses on traditional “drawdown" private real estate funds, and not evergreen and/or other creative private access structures, or public real estate investment trusts (REITs).

Matt Malone, head of investment management at Opto, breaks down the differences between REITs and private real estate funds.

Why you should be interested in private real estate

A large and diverse market, real estate spans a wide variety of property types and sectors. When you invest in private real estate, you are typically directly investing in (or providing financing for) real, tangible, privately-held assets.

And while the media has been quick and largely correct to point out the challenges facing commercial office space post-pandemic, there is much more to this asset class than office space, including multi-family residential, retail, industrial (e.g., data centers, warehouses), and hospitality real estate.

Some of the potential benefits - which vary depending upon the strategy - of investing in private real estate funds include:

• Consistent income/yield. Returns are typically derived from cash flows generated by rents. 

• Long-term capital appreciation. Returns may also come from selling an investment property, or from charging higher rents justified by improvements to a property.

• A potential hedge against inflation. The limited supply and high demand for higher-quality properties may offer some protection from inflation - real estate values tend to rise with other prices. In addition, rental income can be periodically adjusted in response to inflation. For debt-focused strategies, funds using fixed-rate mortgage financing may benefit from inflation because the real value of their debt decreases over time, making the relative cost of borrowing cheaper.

• Low correlation to traditional stocks and bonds. Real estate markets tend to be highly localized, so the economic conditions, zoning laws, and supply/demand dynamics that affect performance typically do not correlate with broader financial markets. Also, since it is usually hard to sell real estate investments quickly, they tend to be insulated from short-term market shocks.

• Outsized returns. In certain economic environments, real estate demand can strongly outstrip slow-to-adjust supply, with the potential to generate outsized risk-adjusted returns for funds.

What is private real estate?

Private real estate funds vary widely in terms of underlying assets, investment mix (debt and equity), and investment strategy. 

Given the sheer number of potential investment properties, the different types of strategies, and different levels of deal access, it is unlikely that any two real estate funds will be identical. 

The long-term nature of these investments means that fund managers must be able to successfully evaluate and select the right markets, sectors, and properties for “right now,” as well as for the future. Real estate strategies need varied levels of hands-on active management. Necessary skills can range from basic property management, to a deep knowledge of debt restructuring, to the ability to negotiate favorable refinancing deals, and more. 

The strategies…

Strategies are typically divided into (from lowest to highest risk): core and core-plus, value-add, and opportunistic. Core is most focused on generating regular income/yield, while opportunistic strategies may seek returns from capital appreciation.

Core: Considered the most conservative of the strategies, core funds invest in prime properties in popular locations. Beyond normal maintenance costs, these properties do not typically have significant expenses or need improvements. They are usually fully occupied by tenants with long-term leases and whose rents generate the property’s cash flows, which are the source of core funds’ returns. 

Core-plus: Returns from core-plus funds also come primarily from their properties’ cash flows (rents), but with some assumption of value appreciation. Properties in this category are usually fully occupied and in prime locations, but may not be quite pristine quality. Money may need to be invested in the property, which may make cash flows less predictable, but should boost the property’s value and justify higher rents. 

Value-add: Returns from value-add strategies are generated through actively making strategic improvements to properties - typically in subpar condition - that have little to no cash flow. This may involve physical renovation, or operational restructuring to improve cash flows via increased rents and/or reduced operating costs. The goal is to enhance the value of properties so they generate higher returns when they are sold or refinanced.

Opportunistic (distressed): The riskiest of the real estate strategies focused on capital appreciation, opportunistic funds find unique or special situations - often facing financial issues - to turnaround and, in theory, generate higher returns than other strategies. Properties of this type require a high degree of active management, which could mean substantial physical renovation or operational restructuring to favorably reposition the property in the market.

How do I invest in private real estate?

While making direct investments in real estate is possible, it is highly impractical and risky for individual investors. A simpler approach to private real estate investing is through a fund.

These funds are set up as “limited partnerships” (see box below) and the money is contributed by individual or institutional investors, who are referred to as limited partners (LPs). The fund manager or general partner is responsible for making and managing investments with the money contributed by the LPs, who are generally passive.

Private real estate investments are long term. During that time, your investment is largely illiquid. You cannot sell your investment in private real estate in the same way you can a publicly-traded REIT. 

However, private funds do not require the entire investment upfront. They take a “just in time” approach to collecting your money. Committed capital is the money you agree to invest in a fund throughout its life. Called capital is the money the fund manager collects from you as it makes investments. 

You get capital calls throughout the investment period, typically one to three years. This means you do not have to provide all the money upfront, but will need to have ready cash when there is a capital call. These calls can come with little notice and you need to respond quickly.

Fees in real estate funds

Private fund fee structures are different from the flat fees you pay for a public REIT. Designed to incentivize the GP to do their best, there are generally two types of fees, as well as some general expenses. We talk about this in more depth here, but in short…

Management fees

First, there is an annual management fee that covers most of the fund’s basic operating expenses. This typically includes salaries, office rent, legal and due diligence costs, and other administrative costs. This fee usually ranges from 1% to 2.5% of the capital you committed.

Performance fees

The fund manager also receives a share of the fund’s profits, commonly called carried interest or just “carry.” The standard carry is around 20%, but it may vary depending on the terms of the fund agreement. 

Carry is typically subject to a hurdle rate. This means that performance fees only start to accrue after investors get their capital back, as well as the pre-approved hurdle rate. At this point, the GP receives 100% of returns until their carry matches what they would have received if the hurdle rate did not exist.

Aligning interests

As this performance fee structure makes evident, there is strong alignment of interests between investors and the fund managers.

Put simply, if a fund is successful, the manager profits. If not, they take the losses alongside their investors. Of course, we should note that management fees provide a small amount of income for the manager throughout the fund life.

Risks…

As with any investment - public or private - it is possible to lose your money. Real estate investments are susceptible to economic pressures and interest rate changes, which can create tight borrowing conditions and elevated refinancing costs. Some properties may be exposed to unpredictable catastrophic risks, such as hurricanes, flooding, and other natural disasters.

By their nature, real estate investments are long term and illiquid. Before making an investment, investors need to determine how much money they are willing to lock up for the duration, which may be 10 years or more.

…and the rewards

Nevertheless, we would argue that with careful fund selection, appropriate levels of diversification, and the support of the right partners, an allocation to private real estate can play a highly constructive role in a well-balanced portfolio.

Private real estate is a diversified and constantly evolving market, offering a variety of options for income generation and capital appreciation, as well as a potential hedge against inflation. It has the potential to usefully augment the income-focused component of a well-balanced portfolio and provide diversification - enhancing portfolio risk-adjusted returns via their limited correlation to public markets.

Still curious? Click on the real estate tab on our Insights site.