After a period of uncertainty, is there a place for real estate in your portfolio once again?
Following a volatile couple of years, private real estate is regaining some of its status as an asset class with solid investment prospects. Like any investment, however, diversification is essential when trying to optimize returns.
Through 2006 and 2007, the real estate investment market surged. The enthusiasm was supported by a four-year run from 2004 through 2007 in which average commercial property prices posted strong gains. In turn, total returns on institutional-quality direct real estate investments jumped by double digits year over year.
But in early 2008, as the world’s credit markets hit severe turbulence, the real estate market turned sharply. Accordingly, two straight years of considerable losses sparked a divestiture in real estate investments.
Over the past few years, sentiment has begun to reverse course, with solid returns in some markets fueling a renewed attraction to real estate investments. Demand for private U.S. real estate has also been fueled by interest from overseas investors, who see the U.S. as a safe haven compared to real estate opportunities in less-stable countries. Even for U.S.-based investors, private real estate investment should remain part of a broader portfolio strategy.
“Everyone has heard the story about how someone hit it big by investing in private real estate, and they feel like they missed out,” says Kurt Prusener, a Chicago-based senior asset manager in Northern Trust’s Real Estate Group. “In general, though, we stress that it is an alternative asset class that is a complement to the traditional portfolio due to its low correlation to stocks and bonds. It’s a long-term investment with unique characteristics such as an inflation hedge, an income stream and long-term capital appreciation.”
Alternatively, publicly traded real estate investment trusts (REITs) give investors more indirect exposure to the real estate market. Instead of owning the property, the investor is a shareholder or unit holder in a company that owns and manages the real estate. The company pays its share/unit holders a dividend.
“Private and public real estate can provide investors exposure to different sorts of risk premia, such as term, credit, and the illiquidity premium, says Katie Nixon, Chief Investment Officer for Wealth Management at Northern Trust.
Tips For Investing In Real Estate
One of the fundamental factors in assessing the suitability of a real estate investment is its capitalization rate, commonly referred to as its cap rate. This figure represents the annual yield a property is expected to generate from the property’s net operating income (NOI) (rental income minus operating expenses, excluding debt service) divided by purchase price.
Kurt Prusener of Northern Trust’s Real Estate Group lists factors important in setting a cap rate threshold:
- Type and location of property
- Quality of the structure
- Status and quality of the tenants
Allowing for all of those variables, an investor seeking a 10-percent cap rate would be willing to pay $1 million for a property that generates an annual net income of $100,000.
But if an investor is amenable to a 9-percent cap rate, that same property that generates an annual net income of $100,000 can be sold for a bit more than $1.1 million.
Over the past few years, as interest rates and bond yields have lingered at historic lows, some investors have agreed to cap rates as low as 4 percent, which translates to a $2.5 million value on a property that pays out $100,000 a year.
Investors who pay such a premium, however, face considerable risk of getting squeezed. “As yield rates go up on non-real estate investments, money will flow toward those assets and real estate buyers will demand higher yields,” says Prusener. “Because the cash flow will generally remain the same in the short-term, based on contract rental rates, the property value to another investor will decline.” Though the cap rate will not reflect the debt service paid, a buyer will take into consideration the current interest rate environment and cost of capital (debt service expenses) in determining the price he or she will pay for the income stream recognized.
So if the goal is to incorporate real estate investments into their portfolios, investors must clearly understand the cap rate that they will accept as well as the cost of capital they must pay to finance an acquisition.
Normalized Returns Likely on the Horizon for Real Estate Investments
According to an April 2014 report from the Urban Land Institute and consulting firm Ernst & Young, returns in the commercial real estate industry are projected to hover much closer to the 20-year average of 9.3 percent between now and 2016 than they did in 2010 to 2013, when returns averaged about 12.23 percent per year.
As part of the broader expectations, the report projects that returns in the retail, industrial and apartment spaces will taper modestly from 2013 levels through 2016. Meanwhile, returns on office properties are projected to remain steady, bolstered by an expected decline in office vacancy rates.
One potential damper on future returns is higher interest rates, which Northern Trust believes the Federal Reserve may start implementing in 2015. Such conditions result in higher borrowing costs for developers. Higher interest rates can also affect the value of properties, which tend to decline as investors demand higher cap rates – or yields – from real estate investments.
“Over the past few years, apartments and farmland have been really hot, with values steadily going up and cap rates really being pushed down,” says Mike Papierski, a Chicago-based national practice leader in Northern Trust’s Real Estate Group. “The challenge comes as everyone sees the easy money, but the cap rates get so low that it doesn’t compensate the investor for the risk they are taking on – especially in a market like farmland, where we believe lower commodity prices will constrain appreciation for the next two or three years.”
Building Real Estate Investment Exposure
As a rule, Papierski and Prusener suggest investors allot no more than 15 percent of their entire portfolio to private real estate. Within these parameters, investors might explore the following investment opportunities:
REITs: Single REITs generally offer access to a specific niche in the real estate universe, while an REIT mutual fund offers diversification across many types of property types REITs. REITs and REIT funds offer liquidity and low investment minimums. As performance tends to more closely align with stock market returns, however, performance may not correlate with actual property values.
Open-end real estate funds: These funds are portfolios of brick-and-mortar investments overseen by a single management team, which determines the focus and scope of the fund. Minimum investments can be as high as $250,000, but there are no capital calls or mandatory follow-on investments. The value of such funds is made on a quarterly basis, so liquidity has limits.
Private equity real estate: Private equity real estate is an asset class in which early investors fund the purchase of real estate assets and are subject to capital calls for the life of the fund. Investments, which are handled by a single sponsor, are generally locked up for seven to 10 years as the sponsor acquires assets and repositions the portfolio – including strategic selling – as desired.
Individuals may seek out their own investment properties, but Papierski and Prusener are wary of investors directing their entire allocation into a single commercial property unless their whole portfolio is greater than $30 million. Even then, the risk stemming from the non-diversified approach can be considerable.
“Bricks-and-mortar require expertise and intensive management, even in an investment-grade asset,” says Prusener.
Vacation Real Estate as an Investment
One real estate investment that ideally serves multiple purposes – rest and relaxation in addition to potential returns – is vacation property. As more U.S. residents seek out properties in beautiful overseas settings, Papierski acknowledges the attraction but cautions that such decisions shouldn’t be made without extensive due diligence.
“Obviously, you must understand the political environment of the country, but you also need to be knowledgeable about the specific market you’re looking into. How capable are you of managing the property from afar, or putting a good manager in place?” he says.
If overseas property is to be included in a trust, investors should contact a trust attorney familiar with the laws of that particular jurisdiction. Many foreign countries do not recognize U.S. trusts and may have ownership restrictions as well as specific recognized entities that are permitted to hold real estate. Investors may also be required to create a separate will in that country to properly deal with the disposition of the real estate.
In short, regardless of the type of real estate in the equation, Papierski emphasizes that it’s essential to understand the complete nature of the investment: both the potential upside and downside.
“Part of the attraction of a real estate investment is the current income, but the appreciation should only be considered as part of a long-term gain,” he says.