Diversify.........with private real estate
Brad Clark
CEO, Founder, COO, Interim Exec. Two $500M+ exits, two public platforms, six start-ups, ten P&L's.
By Brad Clark
Most would agree that putting all your investments in one stock is not wise; diversification makes sense.?And now that the market has reached not only new heights but also new levels of volatility, crystal balls abound whether, when, and how big a “correction” might be. Diversifying out of publicly traded stocks into a different type of investment might make even more sense than ever. Investing in private real estate is unique in its ability to not only diversify a portfolio but also enhance returns, avoid public market risks, simultaneously provide both cash dividends and capital appreciation, and reduce volatility all while delivering tax advantages.
How does a private real estate investment do that?
Let’s start with some definitions for context.?Modern portfolio theory[1]?is a way to evaluate risk and allocate your holdings, or portfolio to target a return consistent with your risk appetite.?Simply put, it’s about diversification.?Diversification[2]?means investing in asset classes that are not correlated.?The gains from some asset classes will offset the losses of others resulting in lowering your portfolio risk below the sum of the risks of the assets.?Diversifying asset classes moderates risk, but what is an asset class? And what does correlation mean?
Asset classes?are a grouping of investments with similar characteristics that are subject to the same laws and regulations.[3]?The 10 generally tracked asset classes are five different Equities (Large Cap, Mid Cap, Small Cap, Emerging International & Developed International); Fixed Income; Diversified Portfolio; Cash & equivalents, Commodities, and Real Estate.?Commodities and Real Estate are two examples of what are referred to as Alternative Asset Classes.
Alternative assets, including commodities and real estate,?are unique assets that behave very differently than stocks, bonds, or cash.?They tend to be less liquid than traditional investments, have a low correlation to equities, and can serve an important diversification function in a portfolio, thus enhancing overall returns.
Each sub-class has distinct advantages and disadvantages to equities but when comparing real estate specifically it diversifies risk, enhances returns, tends to be less volatile, is slightly lower in expected returns, and has a very low correlation.
Correlation?is a measure of how closely two things move together in the same direction and is measured with values of +1 to -1.?A “+1.0” is a perfect positive correlation; two assets move exactly the same.?A “-1.0”, is a perfect negative correlation when one goes up, the other goes down.?0 means there is no relation, they act independently of each other.
Stock from the same class are highly correlated, (> +0.8) and even stocks from different classes are correlated at just a slightly lower level.?Bonds have historically been slightly negatively correlated and real estate is almost completely non-correlated at +0.07 to stocks over the last 30+ years.?[4]??That means real estate is fundamentally diversified from stocks.
How to compare asset classes.?A standard way to compare and contrast asset classes and their performance over time are by an asset class return quilt.?Each asset class has a color assigned and every year are stack ranked with the highest performing asset classes at the top and the lowest at the bottom.?This quilt shows a comparison over the last 10 years.
Performance drivers for any asset class in any given year are typically different from another asset class.[5]?How different those drivers are between asset classes is core to determining correlation or diversification.?And while there are no guarantees for future performance, real estate has performed in the top tier of asset classes 7 out of the last 10 years.?Also, on a risk-adjusted basis, it is the #1 performing asset class.[6]
However, the asset class returns quilt reflects only data on publicly traded instruments.?For real estate, it is the Dow Jones US Select REIT Index that measures the performance of publicly-traded real estate investment trusts (“REIT”s) and REIT-like securities.?It is a proxy for direct real estate investment and tries to approximate only the value of the real estate, not direct payment of distributions.
What happens when alternative asset classes are included in a portfolio??For portfolios following Modern Theory, alternative investments have become a significant percentage of holdings. The Chief Investment Officer of the Yale Endowment, David Swensen popularized the?“20% rule”?advocating allocating at least 20% of a portfolio towards private alternatives with little/no correlation to traditional public-traded assets.?
The 20% Rule appears to be delivering results.?According to a study by Blackrock, significant portions of a portfolio allocated to alternatives contribute more to the overall performance than merited by their volume.?For example, a portfolio in 2019 derived 40% of its return from alternatives that represented 26% of its holdings.[7]
Public Markets vs Private Real Estate Transactions.?There are additional advantages to investing in?private?real estate vs assets traded on?public exchanges.?Private market real estate trades are just that.?Private transactions; and provide distinct advantages to the right teams.
Public markets are affected by macro forces, such as a teaser of the Fed’s next quantitative easing announcement or a flurry of memes on Twitter, that cannot directly impact the private sale of a warehouse in the same way.?Public markets set prices. Information is readily available. The ease/speed of transactions has reached new heights and transaction costs have dropped dramatically.
The chart below outlines key distinctions between investing in public vs private markets.?While at first glance private real estate transactions may appear to be at a disadvantage, when approached properly and with the right team, these same factors can provide a distinct advantage to investors.?Let’s review a few of the distinctions.
Illiquidity – Is this a bad thing??In order for publicly traded assets to remain liquid, they must hold a percentage of liquidity I.E. (cash) for client redemptions.?Thus, the entire portfolio is not invested and lowers the potential return.?If liquidity is matched with a client's long-term hold strategy, we view this as advantageous.
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Opaque – Maybe.?If you choose the right investment partner, there should be complete transparency within the documents, operating agreements, and legal entities established.?Can you go point out the specific property owned inside of a publicly-traded REIT??Our investors can.
Frictional – To assume there is no transaction cost in publicly traded real estate deals is simply false.?Generally, due to the size and scope of publicly traded deals, transaction costs get buried in the details.?We believe exposure to hard costs helps keep them low and reasonable vs. buried in a prospectus.
Fragmented – A good property will have a buyer whether it is privately held or owned within a public REIT.?In fact, many times the private markets can take advantage of inefficient segments of the market that are too small for publicly traded REITS to operate.
In sum, in addition to the benefits to the overall portfolio as an alternative to equities, with private real estate transactions, the very things that could be seen as a disadvantage to public markets, gives those with the necessary knowledge, skills, and resources a competitive advantage to earn above-market returns.[8]
Yield and Appreciation, simultaneously.?To oversimplify, when investors pick an asset class, they generally are limited in picking either current income or capital appreciation. Of course, there are exceptions, including the catch-all asset category of “Diversified Portfolio”.?But if an investor chooses income, they will allocate part of their portfolio to the fixed income, cash, or perhaps commodities classes.??If they choose capital appreciation, it will be primarily the stock asset classes.
Real Estate can play in both arenas.
Investors typically evaluate private transactions based on two factors.?First, the cash-on-cash returns or yield the project delivers. Simply put, if they invest $100, they expect a check annually of $8-$10.?Or an 8-10% yield.??Depending on the property, that yield could be higher or lower and if cost segregation is employed, every year when they receive their K-1, they might also get a nice tax deduction to offset some of that income.
On those same transactions, usually, a sale is also anticipated.?The property is sold at the current local market value, the mortgage is paid off and after-sale expenses are paid, the remaining cash is distributed to the investors as a capital gain.?That reflects capital appreciation on the asset, just as if a person bought a share of stock for $100 and sold it 5 years later for $150.?While there is a current discussion of eliminating this portion of the tax code, today there is then an opportunity for the investor to postpone recognition of that capital gain through a 1031 exchange, either directly or through a Delaware Statutory Trust intermediary.
The total return on a private commercial real estate investment is typically this combination of cash yield and capital appreciation on sale.?And that blended return, along with diversification arguably puts real estate into a unique asset class all its own.
Private real estate is a unique diversifier?of a portfolio because:
Prevail Innovative Real Estate is pioneering a different approach to provide access to curated private real estate transactions that provide diversification to an investor’s portfolio.?For more information, contact Brad Clark, Managing Director at?[email protected]?or call 913-689-2449.
DISCLAIMER: This is not an offer to sell securities. Any person, entity, or organization must first be qualified by the company and read all the offering documents, and attest to reading and fully understanding such documents.?This presentation should be construed as informational and not as an advertisement soliciting for any particular purpose. Prevail Innovative Real Estate Opportunities and Prevail Strategies, LLC has common ownership. It is not intended, and should not be relied on for, tax, legal, or accounting advice.