Should You Be Investing in Real Estate?

Finance | Provided by Cornerstone Advisors

Living and working in the dynamic and rapidly growing Pacific Northwest, home-owners have experienced large gains for the last several years. Given the volatility and uncertainty in the equity markets and the low yields in the fixed income markets, many investors desire to increase their exposure to real estate to include assets such as apartments, hotels, retirement communities, office buildings and retail properties.

A Cornerstone Real Estate Primer

Real estate is a hybrid asset class offering potential price appreciation in addition to recurring income. Many strategies require the implementation of “value-added projects” as their catalyst for attractive returns. These projects can include renovations, construction, implementation of a marketing plan, re-capitalization and so forth. However, you can often be compensated with cash disbursements from regular operations while waiting for the value to materialize Investors can also see returns that result from one-time events such as a property refinance or partial sale. These kind of returns are unique to private real estate and aren’t typically available in similarly illiquid investments such as hedge funds and private equity.

The historical return profile of private real estate is favorable. As measured by the industry standard NCREIF Index, published by the National Council of Real Estate Investment Fiduciaries, returns have averaged 9.2% for large core real estate holdings over the past 37 years. Returns have closely matched their long-run average over the past decade, although they were more volatile.

Inflation

Given the impressive level of monetary stimulus from the U.S. Federal Reserve, European Central Bank, Bank of England, and Bank of Japan over the past six years, many investors are concerned about the potential for future inflation. Private real estate has a unique embedded inflation hedge as long-term leases can be tied to the Consumer Price Index while shorter-term leases can be renegotiated upward. This flexibility results in revenues that can keep better pace with inflation. Similarly, property-related expenses can be passed through to tenants. Inflation also impacts the value of land and materials, potentially increasing the value of land and current structures.

While often spoken of in generalities, ‘investing in real estate’ is a complex and diverse set of opportunities. Investors must determine which method or investment vehicles to utilize.

Access

There are three main paths to accessing real estate investments that will be discussed below.

  • Directly purchase land or income producing real estate
  • Buy a publicly traded real estate investment trust (REIT)
  • Buy a diversified, private, real estate fund

 

1. Purchase Directly

Investing directly in specific real estate deals typically raises difficult questions for investors. For example, questions that need to be addressed include:

  • Will I be personally liable for the mortgage debt?
  • Should I self-manage or hire a property management company?
  • How should I hold the property to avoid potential legal issues?
  • How do I assemble a diversified real estate portfolio that includes a wide variety of types of properties in a wide variety of geographical locations without requiring a staggering sum of money?

Many investors do not have the time or expertise to invest in real estate directly. Therefore, institutions and individuals primarily invest through REITs or private limited partnership structures (often referred to as private real estate funds) where they are passive investors with minimal involvement.

2. REITs

Investopedia defines a REIT (Real Estate Investment Trust) as “a type of security that invests in real estate through property or mortgages and often trades on major exchanges like a stock.” REITs provide investors with a liquid stake in real estate. They receive special tax considerations by avoiding corporate tax and pass income and gains to the shareholders. With an income focus, the REIT yields are typically higher than the broader stock market and typically offer high dividend yields.”

Publicly traded REITs are often implemented in portfolios in order to gain access to real estate assets. REITs have an advantage over direct real estate purchases in that they typically have more diversification and offer professional management.

However, REITs can be more volatile and less of a portfolio diversifier than private real estate funds. REIT volatility has historically, and at times significantly, outpaced the volatility of private real estate. Additionally, REITs are much more sensitive to movements in public equity markets; therefore, REITs do not act as a diversifier during turbulent market environments. During the Global Financial Crisis (2007-2009), REITs had an equity market sensitivity (EMS) of 1.33, versus only 0.27 for private real estate.

Tax Efficiency

REIT income is taxed on an annual basis, typically at ordinary rates (as much as 40%) regardless of the timing of your investment. In contrast, many Private Real Estate funds generate similar cash flows but low or no taxable income in the early years due to depreciation expense (which is a non-cash expense which does not impact distributions or market value).

Eventually capital gains are due if the property is sold at a gain. However, the tax deferral can enhance the tax net of tax cash flow in the early years of private real estate funds and recapture of depreciation claimed in prior years is taxed at a maximum rate of 25%, a favorable tax rate for investors in higher tax brackets. In the event of a loss, a private real estate fund typically gets better tax treatment for investors in high tax brackets than for a REIT investor.

3. Private Real-Estate Fund

Private real-estate funds are a broad classification of limited partnership investments that typically own a broadly diversified portfolio of properties. They are typically diversified by location, type of property and vintage year of acquisition.

The selection of investments is left to the general partner, a skilled business operator, who typically has 3-4 years to identify multiple investments and 5-7 years to sell them. In this fund structure, a limited partner’s capital is “committed” up front but is invested over time as opportunities are identified. In later years as investments mature and are sold, the proceeds will be “distributed” back to the limited partner.

How Does Cornerstone Approach Private Real Estate?

Cornerstone does not explicitly target allocations to certain property types or geographies. Instead, we prefer to have a flexible approach that allows us to capture relative value in property type, geography, and capital structure. With that in mind, we have a long history in the office and apartment sectors. We believe these property types provide stable and recurring income from operations, as well as appreciation potential due to the value-added management of an asset. In the past, these two sectors have represented 60%-65% of our real estate exposure.

While varying the property types we target is one way to diversify a real estate portfolio, we also find it important to select a diverse group of strategies within each property type. In a typical fund, we expect to make 8-12 investments with each investment representing anywhere from one property to a hundred properties or more.

Many of Cornerstone’s investments are in discretionary funds where the manager has the right to call capital to acquire properties. In some cases, Cornerstone can assess the financial merits of potential investment assets prior to allocating money to a fund and at times, we may be able to review the majority of the underlying assets prior to our commitment. While this is certainly helpful in assessing our desire to participate in a fund, it is not imperative, as we thoroughly assess potential partners’ past performance track records, investment analysis, quality of operations, depth of team, reporting abilities, and investment thesis for new opportunities. As a general rule, we insist on regular transparency throughout the life of the investment.

So…Is Private Real Estate Right for You?

If you’re interested in private real estate investing, there are a number of considerations. First of all, remember that real estate investing can be an illiquid investment and should be limited to the portion of your portfolio that can be invested for up to 10 or more years.

The next step is choosing how you want to access the real estate market. Ask yourself if you have the background for the appropriate due diligence and the time, experience and capital to invest in and manage properties directly. If not, direct investing might not be right for you. REITs offer investors much more structure, flexibility and certain tax advantages. However, REITs come with their own challenges and limitations including volatility and sensitivity to public equity markets. Becoming a limited partner and investing through a private real estate fund managed by a skilled general partner is the other option. But, be aware that there is a very wide dispersion of investment returns for private real estate managers, so it is critical to identify the most successful ones. Finally, always remember that in order to mitigate some of the risks associated with the asset class, it is important to diversify your investments over time, investment focus and geography.

As an investor, there is great opportunity in private real estate but there is also corresponding risk that should be understood, carefully considered and mitigated to the extent possible through thoughtful implementation.

If you have interest in private real estate investing with Cornerstone and would like to see our longstanding track record in this asset class, please contact Bryce McDonald at Cornerstone Advisors by calling 425-646-7600.



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