Private market real estate: assessing key opportunities and risks

As with any asset class, real estate is not without risks. The economy’s trajectory, monetary policy and uncertainty surrounding continuing trade negotiations are some of the variables expected to influence investment activity in the foreseeable future.

There are a growing number of private market alternative investment options that can be considered. Some of these require investors to meet eligibility requirements. There are a variety of potential benefits, but also unique risks associated with these strategies.

Four benefits:

1. Lower reported volatility. Real estate assets often undergo appraisals, ideally using independent third parties. They factor in the cash flow of operating assets, capitalization rates, supply-demand dynamics, comparable property sales and other considerations. There can be a lag between current market and economic conditions, and property valuations. This can smooth out the reported performance and volatility of private market real estate investments. Combined with a lower frequency of valuations — often quarterly — this stands in stark contrast to day-to-day and intraday changes in the prices of publicly-traded real estate companies and real estate investment trusts.
2. Lower correlation. Real estate has historically shown lower correlation to equities over longer timeframes. This can change in periods of higher distress, where dislocations in financial markets ripple across the economy and cause rising correlation between asset classes. Generally, however, alongside high-quality fixed income and other asset classes, it can help mitigate equity market volatility as part of a diversified portfolio.
3. Potential hedge against inflation. Real estate has natural advantages in long-term potential to preserve purchasing power. Property values have historically delivered positive real returns (adjusted for inflation) over time, though performance varies based on sector and start/end dates. Additionally, where long-term leases with tenants exist — such as with industrial and retail assets — increases in rent are often built in over the term. These attributes are also important to help manage operating costs for real property that tend to rise over time.
4. Potential for tax-efficient distributions. The types of distributions and how they are treated for tax purposes are based on different factors and can change at any time. However, there are opportunities to benefit from a diverse mix of distributions. This can be attractive for those investing in private real estate strategies in non-registered accounts. Sometimes a portion, or all, of a distribution could be classified as return of capital, usually not taxed in the year it is received. However, it does normally result in deferred capital gains by reducing the adjusted cost base of the investment. This can be attractive for investors, whereby some planning to determine optimal timing for disposition makes sense to trigger such capital gains factoring in their future needs and tax circumstances.

Private market risks

The need for a robust process to assess the suitability of investments is necessary to ensure a proper fit with a client’s risk profile, long-term goals and preferences. With private market investments, this can be even more significant as available information, target markets and investment philosophies can vary significantly between strategies.

Five risks:

1. Strength of the investment team, people and processes. Conducting in-depth due diligence on the company and team at the heart of an investment strategy is critical. A strong understanding of their experience, past track record and investment objectives is a must. Also, do your due diligence: have there been any legal or regulatory issues previously or currently facing the firm or its representatives?
2. Financial and leverage risks. Leverage is often considered an attractive tool in real estate to enhance wealth creation. Pushed to excessive levels, high leverage can turn to a headwind, impacting cash flows and amplifying the risk of equity losses to investors if property values decline. Are loan-to-value levels stable, rising or declining and why? What does the maturity schedule look like? Is it diverse across a longer time horizon or concentrated? Refinancing risk increases if borrowing costs rise, putting more pressure on distributable cash flow to investors even if other elements like vacancy rates remain stable. Factoring in expectations for interest rates alongside the maturity schedule can be a valuable risk management exercise.
3. Illiquidity. This can be thought of as the price or premium paid in exchange for the potentially lower volatility these strategies tend to exhibit. There are times where private market investment firms may gate access to investors’ capital (limiting access based on specific conditions) or halt redemptions altogether. It is critical to understand the measures firms can take in limiting access to funds and whether such risks are appropriate prior to making any investment decisions.
4. Conflicts of interest. Having alignment between the issuer, the investment management team and investors can help improve the likelihood of meeting investor expectations over the long term. If there are non-arm’s length relationships, advisors need to understand whether they create incentives to place the interests of one or more stakeholder groups ahead of others. A good approach would be to have a thorough understanding of industry standards to be able to compare individual strategies and identify where and why some investments may be different.
5. Fee disclosures. Traditional mutual funds and ETFs often have relatively simplified cost structures. With private real estate strategies, there can sometimes be difficulty fully ascertaining the activities that can incur fees separate from management fees. This can include early redemption fees, performance fees and fees earned on property acquisitions and dispositions. Some fee structures can create potential conflicts of interest and can have a meaningful impact on net returns. A clear fee breakdown needs to be provided before committing capital.

Risk and reward are two sides of the same coin. However, having a robust process to vet potential private market real estate opportunities can improve the chances of achieving investment goals. It also reinforces trust, manages investor expectations and reduces the possibility of unpleasant surprises.

While many firms in the private market real estate industry continue to see growth and attract investment capital, there have been cases where redemptions are gated or halted. Ongoing communication is necessary between advisors, investors and issuing firms to ensure perspectives remain grounded in current reality, based on relevant, timely information.