Real estate agents and investors across the country, from California to Florida, have noticed an uptick in offers submitted by institutional investors (paywall). Large pension funds are competing with investors and homeowners to buy everything: single-family homes, multifamily, commercial spaces — few asset classes are exempt. These deep pockets cannot resist the action, and for good reason. As the co-founder of a company that invests in private real estate, I’ve seen how property investments can provide greater diversification, income and yield opportunities than stocks and bonds.

Managing physical assets, however, comes with its own hassles and overhead. However, to avoid hands-on stewardship, many of these investors are now allocating funds to private real estate funds as opposed to other investment vehicles.

In this article, we’ll uncover how private equity enables institutional investors to reap the many benefits of real estate without inheriting the maintenance and management issues.

Why Institutional Investors Are Banking On Real Estate

According to a joint study by Hodes Weill & Associates and Cornell University, about 30% of large institutions want to increase their allocations to real estate. This increased interest is mainly due to three reasons. Firstly, the U.S. is in a low interest rate environment. Low interest rates reduce borrowing costs, thereby raising return on a property or overall real estate portfolio.

Lastly, agency debt, supplied by Fannie Mae and Freddie Mac, is widely accessible. The ubiquity allows investors to secure federally insured financing, except for distressed assets, such as retail and specific industrial spaces.

How Pension Funds Invest

Unlike the average consumer, large pension funds rarely take a hands-on role when investing in the industry. Rather, investors choose from a menu of real estate investment vehicles, companies and strategies available that allow them a passive participation. In the public markets, investors can allocate funds to real estate investment trusts (REITs) or commercial mortgage-backed securities (CMBS).

Typically, REITs pay out higher dividends than S&P 500 stocks. Additionally, any capital invested in a REIT is highly liquid and thus can be moved in and out as needed. Regardless, there are drawbacks to investing in REITs. REIT dividends are commonly taxed at a higher rate than ordinary stock dividends. Also, REITs are extremely sensitive to stock market and interest rate fluctuations.

CMBS are the other public market option for investors seeking passive action in real estate. Similar to bonds, CMBS act as fixed-income investments securitized by commercial real estate notes on Class A real estate. Prior to 2020, CMBS investors could earn consistent returns, between 1.3% and 2.6%. Unfortunately, the pandemic hit commercial real estate hard, and the sector saw $12.1 billion in CMBS loan default.

Losing ground in the public markets, many large institutional investors have turned to investing in real estate private equity firms.

Why Private Equity Is A Good Choice

Real estate private equity firms have become the investment vehicle of choice for institutional investors because they consistently outperform the S&P 500.

Moreover, unlike investments in public markets, investing in real estate private equity can grant investors greater control and influence over the deal. Private equity firms assume an active role in selecting and overseeing portfolios of real estate assets, directing all aspects of property management — marketing, tenant lease-up, general maintenance, etc.

As a result of this dedicated supervision, returns from private real estate can range between 15% and 20%, three to five points above those earned in public markets. Unsurprisingly, private equity now constitutes over 25% of the average institutional investor’s portfolio.

The Risks Of Private Real Estate

There are, however, certain risks with private real estate investment. In general, assets placed with private equity are illiquid. Most investments prohibit investors from early withdrawals or reselling their interest. Once funds are placed, investors will rarely see big payouts until a successful exit event. This makes it difficult to track an investment’s value and to be able to pivot quickly during a downturn.

An additional drawback to private real estate placement is that additional infusions of capital may be required. Calls for additional capital can occur when there are unexpected expenses related to the construction or management of the underlying assets. As an example, during the early stages of the pandemic, as commercial tenants were not paying rent, many private investors were required to invest even more money to maintain the operating budget.

Lastly, with private real estate, there is the threat of total loss of an investment. However, I’ve found the success stories with private real estate equity pale in comparison to the losses most investors incur. Construction backlogs, rising rates, loss of income and government shutdowns are just a few factors that can cause an investment to drop into the red and for investors to lose money. While private real estate can be lucrative, it is ideally suited for investors with some degree of risk tolerance.

Confidence In Private Equity

Regardless, the world’s largest pension funds and real estate investors remain confident in the U.S. real estate market and are keen to invest in real estate private equity firms. The continued growth in rents, combined with inexpensive debt and volatility in the bond and stock markets, means institutional investors may find the greatest returns in real estate.

Source: Forbes

Polk & Associates

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Polk and Associates is a member of the Michigan Association of Certified Public Accountants, and the American Institute of Certified Public Accountants. The firm participates in the AICPA Peer Review Program, and has always received the highest level of award for its audit practice and quality control.