As family offices and high net worth investors increasingly allocate more capital to real estate, they should educate themselves as much as possible, particularly in this late stage of the cycle, the author of this article says.

A well-entrenched trend nowadays is private investing (private equity, debt, infrastructure, and real estate), and HNW clients are keen for yield in a world where it is hard to find. Interest rate cuts put through in the past few days only make that yield squeeze more serious. (How long we can endure a world of ultra-long interest rates that we have in so many countries is unclear.) Private real estate is an important asset class, and becoming more so. Family offices, and other types of wealth management entities, are important clients in this space. 

To discuss these matters is Durant Bell, executive vice president of high net worth relations and business development at Bell Partners, a multi-family investor and manager. The editors of this news service are pleased to share these ideas; they welcome responses, and caution that the usual disclaimers apply for contributions from non-editorial staff. 

To get into the debate, email tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com 

The author Mark Twain once said, “Buy land. They’re not making it anymore.” These days, this quote could include many real estate asset classes that are built and developed on top of the land, but the spirit of the quote lives on: “hard assets,” such as real estate, that are concrete and tangible hold a certain appeal for investors. 

In what feels like a late-cycle economic environment, many family offices and successful investors are attracted to real estate as an investment. According to EisnerAmper’s 2019 Private Equity Real Estate Market Outlook, managers are reporting a greater appetite for private real estate investment among family offices, which represented 15 per cent of all mandates issued in this asset class in 2018. It is important to understand why this asset class is getting increasing attention and some of the common questions these investors and their financial advisors should ask.  

A growing appetite for real estate
The current recovery is the longest in history, now in its 11th year. Considering the storm of economic headwinds such as the global virus outbreak and resulting market volatility, hard assets have gained favor as an investor’s defense mechanism. The traditional 10 per cent rule of thumb that many institutions and family offices follow for real estate allocation continues to migrate upward - according to a report from Campden Wealth and UBS, the average allocation to direct real estate investment by family offices hit 17 per cent in 2018, up by 2.3 percentage points from the prior year.

Historically, private real estate investment opportunities were largely reserved for the ultra-high net worth and institutional audiences. With the advent of more institutional-quality firms offering private placement opportunities at lower minimum entry points, wealthy individuals and family offices are experiencing what institutions have enjoyed for some time: sound risk-adjusted returns in a “tangible” asset class.  

Private real estate investments continue to gain favor among family offices and high net worth individuals for a range of reasons including:

Income: Real estate can offer fairly consistent current income in addition to appreciation over time, and act as an inflation hedge in periods of interest rate hikes. This is borne out by an analysis conducted by MIT economists based on commercial property data from the National Council of Real Estate Investment Fiduciaries.

Stability: Private real estate is often not “marked to market” daily unlike public equities, so the daily volatility can feel muted by public market standards. Additionally, it has a weak correlation with other asset classes. According to a July 2019 report from Nuveen, private real estate had a correlation to the stock and bond markets of just -.10 and -.14 respectively in the period from 1998 through 2018 (1 means exact correlation, 0 means no correlation and anything below 0 indicates negative correlation).

Liquidity: There is a large buying universe of real estate globally, affording numerous disposition options. According to MSCI, the size of the professionally-managed global real estate investment universe stood at just under $9 trillion in 2018. In addition, real estate has historically been able to access low debt costs relative to other private investment strategies.

Tax Benefits: Under the current tax laws, real estate offers significant tax advantages over other investment options. Assuming that the asset is held longer than one year, for example, the investment can take advantage of the capital gains tax rate vs. ordinary income – for example, in the US, the highest long-term capital gains tax rate (20 per cent) is around half of the highest rate for ordinary income (37 per cent). In addition, real estate often offers passive losses in the earlier years due to accelerated depreciation.

What to consider when making an investment decision
From small apartment developments to towering office buildings, real estate is a diverse asset class, and not every investment is going to be suited for every investor. It’s important for wealthy investors and family offices, especially those who might just be increasing their exposure to real estate, to ask hard questions and conduct extensive due diligence.

Though real estate might be a new sector for many individuals and family offices, some of the same considerations that go into choosing a traditional investment still stand, simply viewed through a different lens. Five key areas that high net worth investors and family offices should focus on when evaluating real estate investment opportunities include:  

Asset and Operator: In horse racing, it takes the best horse and jockey to win. Similarly, in real estate, it is important to not only have a functional asset in a great location (the horse), but also a seasoned, strategic and thoughtful owner/operator (the jockey) guiding the investment decisions. Experienced family offices and high net worth investors recognize the importance of underwriting both the asset and the investment partner.
  
Track Record: Wealthy individuals and family offices should also deeply analyze the manager’s track record, looking not only at how the manager performed over multiple cycles, but also at any sub-optimal investment returns and what the manager learned from these investments.

Fees: There are many ways a manager can get paid for their investment services, including acquisition and disposition fees, asset and property management fees, and a carried interest structure. Astute family offices and high net worth individuals should carefully compare offerings and private placement memorandums to ensure all fees, taken together, are fair and market-based. 

Specifically, Investors should also look out for a “catch up” provision in the carried interest waterfall splits, which can be both significant and punitive to the investor. For context, a catch up allows the general partner (i.e. the real estate firm) to recoup some or all of their co-investment above a certain return threshold before outside investors begin to participate in the splits above this return threshold.  

Communication: Before investing, family offices and high net worth individuals should understand how frequently their general partner will communicate with them (for example, with monthly or quarterly updates), how they will communicate (e.g., through investment portals, written reports and memos, or in person) as well as what will be communicated (i.e., are investors just hearing the good news, or are they hearing all news, good and bad?).
  
Team Incentives and co-investments: Incisive investors should dive into how the firm is compensated, ensuring alignment between the investor and the general partner, as well as how the firm’s senior investment and management team members are paid. Ideally, there should be a strong correlation between the success of the investment and the real estate firm’s compensation, incentivizing judicious investment decisions while also making it difficult for senior team members to leave. Co-investments are also a sound indicator of the firm’s confidence in their offering. The higher the co-investment, the more aligned investors may feel with the general partner.   

As family offices and high net worth investors increasingly allocate more capital to real estate, they should educate themselves as much as possible, particularly in this late stage of the cycle. Real assets are becoming more appealing, but it takes a smart investor, an informed advisor and a skilled owner/operator to turn these into real returns.

About the author
Durant Bell is Executive Vice President of HNW Relations and Business Development at Bell Partners, a national multi-family real estate investor and manager based in North Carolina.