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Why private real estate investing is riskier than you think

Financial Post logo Financial Post 2019-04-22 Martin Pelletier
a view of a city: real-estate© Provided by PostMedia Digital real-estate

With interest rates being so low and volatility in the bond and equity markets so high, it isn’t surprising to see investors beginning to shift their attention toward the private equity market, and in particular the private real estate sector.

Owning real estate can provide many benefits to a portfolio, not the least of which is diversification. An analysis by Wilshire Associates using Standard & Poor’s data found that adding a 10 per cent weighting to REITs into a large cap portfolio boosted the annual return by 60 basis points from December 1991 to December 2018, while reducing the annual standard deviation by 40 basis points.

While it is probably safe to assume that similar diversification benefits can be achieved in the private real estate market, the illiquidity of such investments and what at times can be a lack of transparency can make it more difficult to measure those benefits.

Despite these issues, the sector is sometimes marketed as a low-correlation or low-volatility asset class. This is not only a false statement but a concerning one because most often the underlying assets are not marked-to-market on a regular basis and if they are, the results are smoothed via appraisals.

Abraham Park, an associate professor of finance at Pepperdine University’s Graziadio School of Business and Management, provides a great illustration of this in the Graziadio Business Review:

“The existence of appraisal smoothing significantly reduces the usefulness of real estate rates of return series computed from unadjusted appraisal data, particularly because the variance measurement is artificially depressed,” he wrote. “This type of smoothed series underestimates the riskiness of the real estate asset class and also distorts its correlations with the rates of returns of other assets.”

As a result, while private real estate may provide the appearance of being less volatile than REITs, the only way to find out the real value of an asset is when you try and liquidate your position — and good luck doing so given most investments are locked in and often can’t be redeemed for at least five years.

From a return perspective, Cambridge Associates offers some interesting answers via a study comparing the returns of 942 private equity real estate funds versus publicly listed REITs.

It showed that over a 25 year period to the end of Q1 2017, REITs delivered an annual 11.1 per cent return — 3.9 per cent higher than the 7.2 per cent return of the private real estate funds. Interestingly, private equity real estate funds underperformed despite deploying an average leverage of 51 to 64 per cent compared to only 36 to 47 per cent for REITs. So they had a lower return despite deploying more leverage and therefore undertaking more risk.

Now this isn’t to say investors should avoid the private real estate sector. Large institutions such as pension plans have done fairly well either directly investing in the sector and/or selecting those fund managers who have delivered superior risk-adjusted returns.

But it is also worth noting they have a substantial time horizon and annual cash inflows, along with teams to undertake extensive due diligence. This includes reviewing the amount and type of leverage being deployed, the geographical diversification of the holdings, the type of structure in which the assets are held, any potential tax implications, the specific details of each of the real estate holdings and the management team’s track record and their compensation structure.

a man looking at the camera: mpelletiernp© Provided by PostMedia Digital mpelletiernp

Finally, if you are considering private real estate, don’t go to crazy on the weighting as that could mean forgoing portfolio diversification benefits from other segments of the market such as small and mid-cap equities, emerging markets and even commodities. Be sure to do your homework and at a minimum do an apples-to-apples comparison of performance when benchmarking to the REIT sector.

Martin Pelletier, CFA is a Portfolio Manager and OCIO at TriVest Wealth Counsel Ltd, a Calgary-based private client and institutional investment firm specializing in discretionary risk-managed portfolios as well as investment audit and oversight services.


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