Real estate as a sector is the largest asset class in the world, worth more than USD 630 trillion, higher than the value of listed bonds and stocks combined. It is growing robustly in value (more than 3% per year) and is expected to reach USD 729 trillion by 2028.
Real estate is effectively a staple in investment portfolios either directly or indirectly. Direct investing, such as buying a primary residence is among the very first investments considered by individuals. While real estate is also one of the first indirect investments that individuals will do, sometimes unknowingly, as pension funds invest significantly in this asset class.
Given this exposure, why would an investor further invest in it? To increase returns while at the same time diversifying thanks to private real estate.
Real estate investing can provide a recurring income (rents paid by tenants after expenses and costs) often adjustable to take into account the evolution of interest rates and/or inflation. Real estate units can also be improved, which could lead to capital gains upon sale.
Actively mitigating biases
Investing directly in one or multiple residences amounts to concentrated bets geographically, in terms of assets (residential) and strategy (assets are usually in good shape and well maintained, this could also be described as core investing). Pension funds reinforce this concentration, as they are subject to a well-documented ‘home bias’ when investing. They tend to invest directly in assets that they understand well, and that require little or no direct maintenance. In a total wealth management approach, investors must therefore proactively rebalance their exposure to ensure they only take the risk that they want.
Investing directly is exciting for hands-on investors. However, this activity requires significant capital, expertise and know-how, time and resources (such as qualified contacts), and the financial and technical knowledge to structure and negotiate mortgages.
Indirect investments are typically more attractive to hands-off investors willing to build a portfolio diversified geographically, but also sector-wise and in terms of value creation. This is where private real estate investing can be helpful. The opportunity set is significant: private real estate funds currently manage USD 1.3 trillion, a total that has grown by 14.5% over the last ten years.
Private real estate: Three main investment strategies
Within private real estate, three main investment strategies provide investors with specific risk-return profiles ranging from rather conservative to relatively ambitious. These strategies are delineated by the type and quality of the tenants, the condition and the location of the assets, the type of value creation and the quantity of debt used.
1. Core and core-plus
The most well-known real estate investment strategies are ‘core’ and ‘core-plus’ (more hands-on). These are the strategies that most direct investors apply, notably when buying their primary residence, but are also used in indirect investing with listed funds and real estate investment trusts (REITs). Investors buy good quality units (in need of a refresh, an upgrade, or a management overhaul in the case of core-plus) generating a stable income. Risk is limited. Properties are relatively of low maintenance, often in a prime location, with high-quality tenants and long-term leases. Selling leads to limited capital gains (0 to 10% for core, 10 to 20% for core-plus). Debt usually amounts to 40 to 50% (50 to 60% for core-plus). Investing is usually for 10 years or more for core, seven or more for core-plus.
2. Value-added
Two specific private real estate strategies, ‘value-added’ and ‘opportunistic’, offer access to differentiated sources of attractive value creation. Value-added strategies are typically for knowledgeable owners who are active daily with a team of experts they can rely on. The units suffer from management problems, and/or require significant repositioning, upgrades and improvements. The tenant base might need a significant shift, the units might have occupancy issues and the leases might need an overhaul. Risk is moderate to significant and capital gains generate most of the returns (50 to 70%). The proportion of debt used is 50 to 70%. Investing is usually for five to seven years.
3. Opportunistic
Opportunistic strategies are for expert owners usually committed full-time with a team. Units are subject to a turnaround, are redone from the ground up, and their destination can change. Major structural changes are on the program, as well as redevelopment. The project can take up to two or three years to be realized. Risk tends to be significant and through capital gains. Debt usually amounts to 60 to 80%. Investing is usually for the mid to long-term.
Private real estate in the current environment
Private real estate investing thrives on disruption. Market segments such as commercial and office space are currently experiencing major changes, related to shifts in consumption and work habits, as well as demographic changes. Others, such as logistics space and data centers are under pressure due to environmental concerns. These trends pave the way for private real estate experts to significantly transform these units. Private real estate is an attractive addition to any real estate portfolio, as it could diversify without diluting returns – thus buttering the investor’s bread.