With the passage of the JOBS Act in 2012 (launched in earnest in 2016) and the accompanying loosening of the advertising rules associated with exempt private securities offerings, a world of investment opportunities that were once exclusively reserved for the ultra-wealthy, ultra-connected and institutions suddenly opened up to a broader pool of qualified investors.
The result of the JOBS Act has been not only the proliferation of more private investment opportunities but funds with investor-friendly structures and greater transparency, making private investment opportunities more accessible to individual investors.
One of the industries taking charge in this capital raising rush has been commercial real estate. Investors that had been previously shut out from private real estate investment opportunities suddenly found out what the big deal was.
For decades, ultra-wealthy and institutional investors have reaped the benefits of investing in private commercial real estate funds, including income, growth, and capital preservation.
Compared to publicly traded real estate in the form of REITs, real estate mutual funds, real estate stock, etc., private real estate funds provide superior income returns, better diversification, and stronger risk-adjusted long-term returns (taking into consideration volatility).
Investing in a private real estate fund allows qualified investors to invest in a pooled investment vehicle not listed on a stock exchange.
Since private real estate is not publicly traded, it is not subject to the stock market volatility responsible for most of the fluctuation in the stock prices of public real estate.
The illiquid nature of private real estate investments prevents the volatility of anxious investors found in the public markets. In the private markets, institutions and sophisticated investors understand the long-term nature of commercial real estate investments and returns. They are content to ride out an investment for the long haul.
The reason private real estate offers superior returns compared to public real estate is because private real estate offers the potential for both periodic incomes as well as profits from appreciation. Although REITs are mandated by law to distribute 90% of annual taxable income, thereby providing periodic income, this annual fleecing prevents REITs from achieving any significant long-term appreciation since there are never any profits available for reinvestment.
REITs are generally considered an income play with no expected appreciation. Real estate stocks and mutual funds, on the other hand, are purely speculative and do not offer a periodic income with profits and depend entirely on the hope of an increase in the share price to turn a profit.
That’s the principal reason institutions like endowments and foundations have long invested in private commercial real estate funds because of their ability to generate current income as well as long-term appreciation.
Why are those two elements important to institutions? Because institutions have two investment objectives:
- To provide for the current spending needs of those who rely on these funds today (i.e., universities and beneficiaries).
- To preserve and grow capital for future generations.
Private commercial real estate investments have historically been a reliable source of income plus appreciation, making it ideal for meeting the institutional investors’ goals. In the same vein, ultra-wealthy investors have taken a page out of the institutional investor playbook as well to generate current income as well as preserve and grow capital for many generations into the future.
In the past 20 years, the income return (not including appreciation) of private real estate has beat the income return of public real estate and not just by a little bit.
Private real estate returns beat public REIT returns by more than a full percentage point. When factoring in appreciation – something REITs don’t offer – private real estate delivered a 9.43% average annual return. **
Based on returns alone, the case for private real estate over public real estate is overwhelming. Still, the fact that private real estate returns can be generated at far lower risk than public real estate makes it that more appealing.
It’s the fact that private real estate has a low correlation to the broader markets that explains its low volatility and associated risk. When comparing risk-adjusted returns as measured by the Sharpe ratio, private real estate blew away public real estate by an almost 2.2:1 margin scoring a Sharpe ratio of .87 vs. .33 for REITs.
Institutions and ultra-wealthy investors have flocked to commercial real estate opportunities for decades.
Still, now, thanks to recent regulatory changes, similar opportunities are available to individual investors who were once shut out.
Now that these investors have had a taste of private real estate investing, it’s clear why institutions prefer private real estate over the public real estate – for income and appreciation, all backed by a tangible asset and with less volatility and risk.
Michael Foley
**Source: Black Creek Group using data from Bloomberg; NCREIF; NAREIT. Twenty years are ending December 31, 2017.
