How Private Equity Real Estate Preserves Wealth in a Volatile Economy

This article was originally posted on Origin Investments’ blog.

Investors may need to rethink their strategic asset allocation this year. The near-record economic boom that has lasted a decade won’t continue indefinitely. Plus, even continued expansion comes with risks like elevated valuations in U.S. financial markets; gaps in data that impact effective financial market oversight; and more, the U.S. government’s 2018 Financial Stability Oversight Council Annual Report notes.

The future is already here: Today’s slowing economy stands in sharp contrast to last year’s, when the world was experiencing the best growth since 2010. U.S. stock indexes have posted losses greater than 20 percent and commodities are swept up in trade disputes. But private equity real estate can play a pivotal role in risk diversification. How? A look at how the commercial real estate market works shows why it’s important to have diversified portfolios that include both real estate and securities.

Price Volatility: Real Estate Limits Risk

Compared with a volatile stock market, real estate can be a safe harbor. Most public markets had a down year in 2018, with the Standard & Poor’s 500 stock index falling 6.2 percent, Bloomberg notes. Spikes in S&P indices like the VIX volatility index suggest more price swings to come.

By contrast, prices in the real estate sector appreciate slowly over time, which is why private real estate investments are less volatile than stocks or public REITs. It is held longer than its public counterparts, which gives it more stability. Also, as a tangible asset, real estate retains its intrinsic value. Public companies and intellectual property are more at risk of disruption. Think Kodak or the record industry. Even a piece of real estate going south is still worth something.

Rental income has some stability as well, because rents are set by contract for a year or more. People still must live somewhere, and healthy businesses will still need places to expand. What’s more, real estate generates revenue that is remitted to investors as dividends, which have tax advantages. Taken as a whole, public and private real estate have generated superior risk-adjusted returns.

Trade Wars and Real Estate: More Losers Than Winners

Real estate is not an import, but it’s not insulated from tariffs. Trade wars have winners and losers, and one industry that feels the effects is construction.

The U.S. imposed a 25 percent tariff on foreign steel in 2018, resulting in a higher price, supply shortfall and construction costs rising by about 10 percent in a year’s time, accounting firm RSM estimated. Higher costs will sideline some real estate projects because if rents don’t rise as fast as expenses, it makes less sense to take on new construction risk. Labor shortages will exacerbate the situation, CNBC reported.

While higher construction costs would have an impact on all development-related industries, an experienced asset manager can keep renovation costs in check on value-add real estate properties.

A slowdown might benefit owners of Class A buildings that compete with new construction. Faced with limited space options, tenants may have to accept rising rents. But even with fewer new commercial real estate projects in the pipeline, landlords may not be able to raise rents. A contracting economy may curb demand for office or multifamily real estate.

Overall, a trade war produces more losers than winners. For example, a shrinking market for contractor jobs will undercut economic strengths elsewhere. Private equity real estate may gain pricing power, but only if demand stays strong in the commercial real estate market.

Real Estate Valuations: Correction Coming?

Low borrowing costs have kept money readily available for real estate deals—and bid up prices. The Financial Stability Oversight Council’s 2018 Annual Report finds signs of “elevated” values in both equity markets and commercial real estate. Valuations rose 7.2 percent in a year’s time, led by apartment buildings.

With slower growth and higher interest rates, a price correction seems more likely than not. In a slow-growth economy, borrowers have less money to repay debts. Growth in gross domestic product slowed during 2018, to a still-healthy 3.4 percent in the third quarter. As the Federal Reserve continues to raise interest rates, economists predict lower growth rates ahead, Kiplinger notes.

In private equity real estate, higher costs put pressure on the buyer’s ability to execute a business plan successfully. Those risks translate into a higher capitalization rate, meaning that buyers must be rewarded with either a lower price or a more lucrative income stream.

The question for investors making a strategic asset allocation is whether real estate is just as vulnerable to a correction as are stocks and bonds. A highly leveraged property and a stock bought on margin are both at risk when prices drop. But more broadly, private equity real estate has an advantage because real estate has higher cash flows and dividends, higher debt service ratios and is a tangible asset with liquidation value.

In fact, private real estate deals move at a slower pace than public equity transactions. Rents are locked in. Capital calls can stretch over months or years. Landlords hold their assets. Prospective buyers and sellers bide their time. Once they close a deal, asking prices for comparable properties won’t immediately reflect any price change.

Ultimately, a real estate correction may not happen, or won’t be as deep as a stock correction. Even a 5 percent drop will take a while to materialize in the real estate market.

In an unsettled economy, an investor with long-term goals should keep risk diversification and strategic asset allocation top of mind. As an alternative asset with limited price volatility, private equity real estate can help preserve wealth when financial systems come under stress. The right asset manager also takes an active role in controlling risk. Make sure the manager articulates a clear business plan that anticipates shocks to the system, a history of success in finding and executing deals, a risk management plan, and uses moderate debt when capitalizing his/her projects.