Private Real Estate Investing: Some Facts for Financial Advisors
In CAIS’s view, financial advisors that wish to introduce real estate opportunities to the portfolios of their ultra-high-net-worth clients should be aware of more important considerations than the old adage “Location! Location! Location!” would suggest. Interest in private real estate funds is growing according to data provider Preqin, whose upcoming 2017 Preqin Global Real Estate Report indicates that 25 percent of investors will commit more capital to private real estate funds in 2017, which represents an increase from the 18 percent of investors that felt that way in 2016.1 Preqin asserts that 93% of investors state that the performance of their real estate portfolios met or exceeded expectations in 2016, and 36% of investors interviewed intended to increase their private real estate investments over the long term; in fact, 48% are below their target allocation for real estate.2 As a result, CAIS believes that wealth managers need to be informed regarding the market trends and strategies associated with private equity and private debt real estate opportunities to seek to leverage this asset class to their clients’ benefit.
Market Conditions and Real Estate Funds
The environment for private real estate that was observed in 2016 may have been as good as it gets to fuel the growth of private real estate investing, according to investment advisory firm bfinance.3 The firm contends that the repercussions of the Global Financial Crisis have continued to be felt by the banking sector in the form of increased regulation and capital adequacy concerns, which has reduced lending capacity from banks at a time when investor demand has continued to grow. bfinance cites macroeconomic factors for accelerating this demand, where the ‘lower for longer’ scenario for global interest rates that was perpetuated by monetary intervention, low inflation and weak economic growth has motivated investors to search for yield.
Private lenders have stepped in and addressed some of this investor demand. According to Preqin, $88bn was raised by 178 funds closed by December 2016 and there was $239bn available in dry powder to private real estate fund managers at that time, up from $210bn in December 2015. 60% of those funds closed in 2016 achieved or exceeded their target.
Private Equity and Private Debt Real Estate Strategies
Private real estate funds generally provide ultra-high-net-worth individuals and institutional investors with access to investable property assets not available on public trading indices. A private real estate fund generally uses pooled capital from multiple investors to spread across numerous properties and projects. Funds can encompass equity (ownership and rent opportunities) or debt (loan or mortgage opportunities) investment vehicles and employ a variety of strategies. Mercer’s private real estate educational materials, available on the CAIS platform, indicate that the most common strategies include Core, Value-Added and Opportunistic strategies, as outlined below:4
- Core: These private real estate strategies are generally more conservative and focus on equity investments in stabilized, well-leased properties. They generally involve low leverage and a long-term hold time horizon that is typically 5-10 years.
- Value Added: These strategies generally focus on properties requiring redevelopment or repositioning for alternate use or upgrades. They generally involve moderate leverage and as such offer moderate returns with an intermediate hold time horizon, typically of 3-5 years.
- Opportunistic: These strategies typically focus on investments in real estate-related assets, distressed properties and entity level investing. They typically involve high leverage and seek to capitalize on situations involving economic, financial and property market dislocation. They generally offer the highest risk and hence highest reward of the private real estate strategies.
Private Debt Real Estate Structures
When investing in private debt-based real estate instruments, an investor generally acts as a lender to the property owner or deal sponsor. According to Mercer, several debt capital structures are available as follows:4
- Mezzanine Loan: This structure typically involves a loan-to-value (LTV) ratio of 60-85% with a fixed or floating interest rate. The collateral is a pledge of the owner’s equity interest in the property.
- B-Note: This structure typically involves a loan-to-value (LTV) ratio of 50-75% with a fixed or floating interest rate. The collateral is a mortgage on the property.
- Senior Loan: This structure is the most secure option and typically involves a loan-to-value (LTV) ratio of 0-60% with a fixed interest rate. The collateral is generally the property itself.
Private Equity Real Estate Structures
A private equity real estate investment represents a shareholder ownership stake in the property. Investor earnings are proportional to the amount invested and returns are typically realized as a result of:
- Income streams that an investment property generates, such as rent.
- Increases in property value over time that are realized in a sale.
According to Mercer, the following equity capital structures are available:
- Equity: This structure equates to owner’s equity of 75-100%. This equity is first at risk in default.
- Preferred Equity: This structure typically involves a loan-to-value (LTV) ratio of 80-100% with a fixed or floating interest rate. The collateral is unsecured.
Summary of Portfolio Considerations
Diversification due to low correlation with other asset classes, relatively high and stable returns, and the ability to hedge against inflation are the most common reasons to introduce private real estate products into a portfolio according to Mercer. CAIS believes that these considerations should be balanced with the fact that liquidity is not always readily available however. Savvy wealth managers that are contemplating private equity-based or private debt-based real estate opportunities for their clients should conduct extensive due diligence on the funds under consideration as well as build an awareness of market shifts and trends.
1.NREIOnline, Private Equity Real Estate Funds to Target Alternative Assets, Debt in 2017, January 24, 2017.
2.Preqin, Real Estate Spotlight Vol. 10 Issue 8, December 2016
3.bfinance, Real Estate Debt: as good as it gets?, September 2016
4.Mercer, What is Real Estate, December 2016
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