There is $8 trillion worth of institutional-grade commercial real estate in the world today according to a recent research paper by the benchmarking agency MSCI. Much has changed in recent years: the availability of a wider and more flexible variety of investment channels, for example, plus a complete shift in certain sectors, notably the deterioration in the retail sector as it grapples with the rise of e-commerce.
There is also more spare capital in the market than ever before, desperately searching out alternative sources of yield as interest rates remain stubbornly low. High value investors will invariably have some exposure to real estate and will certainly have an appetite for more, but need to consider factors such as how the sector is evolving, and those emerging themes that are generating new risks and opportunities, plus the variety of ways to access and manage any investment opportunity. This brief document addresses just some of the points for the high value investor to consider.
Start at the start: why real estate?
Before deciding on an investment strategy, it is sometimes helpful to step right back and consider some of the big questions. Why invest in real estate? What am I trying to achieve and do I have the skills and resources? If I do not have the skills or resources, what are my options?
The academic investment case is quite clear: over the long term, Real Estate has generated favourable returns relative to the risk taken to achieve those returns. Returns also tend to be driven by economic expansion, in line with long term rates of GDP growth. In short, a healthy economy inevitably drives property prices higher!
At the individual investor level, the investment case is also straightforward: ‘bricks & mortar’ is tangible, physical, easily monitored and potentially lucrative. Real Estate can provide capital increase on disposal, the investment generally provides an income, is attractive to lenders, and property use can generally be changed or adjusted for new income streams/ capital value enhancement.
Beyond this basic investment case, it is particularly exciting to consider the revolutions happening right now in how we work, study, shop, and communicate and how they impact on the real estate market. It can be a daunting task to find ways to tap into this opportunity, but the smart money is certainly not deterred. According to Knight Frank’s latest Wealth Report, 56% of family offices serving individuals with over $100m of assets said they had increased their exposure to Commercial Real Estate in 2017, and 34% are planning future non-residential property investments outside of their home territory. This all adds up to an incredible mobilisation of capital outside of home markets; it is hard to argue against adventurous behaviour with evidence of 9%+ annualized returns over 20 years from Commercial Real Estate (source, US Real Estate 1997-2017 BCA, MSCI Indices, Bloomberg, Cambridge Assoc).
Rapid changes in the sector – opportunity and risk
Investors have faced a combination of rapidly changing sector dynamics and a yield drought for nigh-on 10 years. They have had to look elsewhere for the income portion of their portfolio and this has led to the increasing popularity of various alternative sectors, some of which are now considered mainstream.
In the case of Real Estate, huge swathes of capital are flowing into logistics; data centres; last mile delivery infrastructure; ‘shiny sheds’ in high growth locations. We are witnessing industrial adaptation of artificial intelligence and robotics; the booming gig-economy and co-working phenomenon (think WeWork!) plus the hugely popular theme of hyper-modern mixed-use student accommodation in stable, reputable education centres. Take some time to research ‘dark kitchens’ and you will see a perfect example of the transformation of a sub-sector, real-time, right under our noses.
The rise of e-commerce is also notable for its pace and scale: Behemoth distribution centres and surrounding infrastructure are now commonplace, but are less than a decade in existence. Consider also the palpable nature of the change on our high streets: a recent study by Emily Want of the FT showed approximately 10% of the UK high street is either already in, or approaching, some sort of insolvency arrangement due to our changes in shopping habits and the rise of e-commerce.
Accessing the themes
Finding opportunity outside familiar hunting grounds is a potentially hazardous pursuit and only those with the deepest resources and ability to absorb taxes, costs and potential losses can go it alone by investing direct or ‘holding the keys’. Where the expertise, local knowledge or resources are not at hand, an increasing number of high value investors join forces and ‘hunt in packs’ through joint investment vehicles, or they outsource to highly specialised sector experts.
It’s tangible, it’s solid, it’s beautiful. It’s artistic, from my standpoint, and I just love real estate.”
Private Equity Real Estate Funds have proven an attractive route for those with large sums to deploy, seeking strong Internal Rate of Return (“IRR”, the common measure of long term success in the sector). These tend to be highly specialised groups of professionals with exceptional networks and can be a vital component of an investment strategy. They are generally territory for those with greatest buying power. On the potential downside, these investments are predominantly illiquid, have no regular income flow to the investor, have very high entry points, use high levels of leverage, and often charge high operational and performance fees.
You might consider co-investing with another high value investor or family office. These partnerships typically take two forms: either a small number of families with similar outlook and expertise wish to join forces for enhanced buying power, scalability and risk sharing; or situations where one family is a more passive player benefitting from the high-expertise of another. Benefits include the significant reduction in costs and fees, substantial returns commensurate with the ability to take greater risks and pickup opportunities swiftly, the opportunity to work closely with another family with aligned interests, and an opportunity to develop the skills and experiences of family members in a very challenging and exciting market.
However, there are downside risks: a tendency toward more ‘personalised’ and informal decision-making, for example, plus the potential for a lower calibre of financial reporting and governance, and the usual problems of meaty and costly litigation if things don’t quite go as planned. If you are going to partner with another family office, make sure you document it precisely when times are good, and have a sound basis of trust, some means of benchmarking your outcomes and clear, regularly reviewed roles and responsibilities.
Real Estate Investment Trusts (“REITs”) offer an ‘indirect’ route to the asset class via a highly liquid instrument. With a universe of well over 600 REITs or similar vehicles globally and in some cases a 50 year track record, this could be considered as part of a wider diversified investment strategy.
REITs are a well-established channel, effectively a corporate body, listed as an exchange-traded security where they are cheap to access and the investor gets maximum liquidity (similar to a major listed security). The investor needs to have the composure to ride the volatility of a daily share price but with the advantage of regular income and with the security of underlying, managed property assets and generally strict controls over leverage.
On the downside, global REIT regimes are not consistent in their definitions or approach, and valuation methodologies vary wildly. Given the sheer breadth of the market, the investor has scope to choose large, well-established REITs in developed markets and ideally take professional advice up front and during the life of the investment. REITs are not to be confused with Open Ended Real Estate Funds, where you must be wary of the risk of being ‘locked in’ in volatile markets (as happened in the Global Financial Crisis and post-Brexit vote for UK Funds). This may not be a problem for an investor with a 25 year time horizon, but if the fund is forced to close it can take a long time to wind up.
Finally, consider carefully how you compare your outcomes. For private, collaborating investors, finding a benchmark or peer group can be challenging but vital to get in place (otherwise success can soon be forgotten or the credit claimed by others!). The private equity sector has been notoriously opaque, but the better operators out there are increasingly contributing to independent benchmarks for peer comparison. There are also major exchange-traded Real Estate benchmarks out there that can provide some basis for comparison, (though by their very nature they can become irrelevant to some situations given the scale of the market they cover).
It is often best to create a benchmark that serves you, that covers a range of parameters relevant to your objectives including risk, leverage, cost management and factors such as IRR. Where you are presented with sellside performance and benchmark information, wherever possible try to find an independent comparison and avoid making decisions based on short term backward-looking information. We are, after all, in the longest bull-market since World War 2!