Higher interest rates, lower economic growth and weak corporate profits are here to stay, and a portfolio made up only of stocks and bonds will generate lower returns for years to come, says a 2016 McKinsey Global Institute. Commercial real estate has the potential to offer long-term returns that are both healthy and stable. More significantly, it is an asset class that can decrease volatility and increase returns when added to a traditional portfolio of stocks and bonds.
But it’s important to understand the many types of commercial real estate investments you can make since each one will have a different potential impact on your portfolio. This comes to mind because an investor recently asked us why buy into our open private real estate funds instead of a successful publicly traded REIT such as Realty Income Corp. (O-NYSE)?
In truth, both products boast similar target returns, and the REIT has a lot going for it, such as:
- • A proven long-term record of 14 percent returns (compared to, for example, Origin Fund III’s targeted return of 17-19 percent);
- • A current dividend yield of 3.76 percent;
- • Dividends that have increased over time; and
- • Liquidity, since the REIT is traded on an exchange and can be sold like any other stock.
Yet when it comes to deciding between a publicly traded REIT and a private equity real estate fund, it isn’t an “either-or” proposition but rather an “and” proposition; they are different types of investments and both can have a place in a strong portfolio. Here’s why, along with four other compelling reasons to invest in commercial real estate through private equity funds:
1. Unlike REITs, private equity real estate isn’t tied to stock market fluctuations.
While public real estate products can be lucrative investments, they are highly correlated to the stock market. That means they rise and fall based on what’s happening in the economy, and their values can be impacted by events that have nothing to do with real estate fundamentals. Because of this, adding publicly traded REITs alone will not necessarily improve your portfolio’s risk-adjusted returns.
2. Public equity real estate funds achieve different investing goals.
When evaluating a potential investment, it important to look at alpha and beta. Beta measures the volatility of a fund relative to the market by gauging how much the fund’s returns move up or down given the gains or losses of its benchmark market index. Alpha is the difference between a fund’s expected returns based on its beta and its actual returns, and it is sometimes interpreted as the value that a portfolio manager adds, notes Morningstar.
Public REITs are a good example of the difference between alpha and beta.
With pubic REITs you are essentially buying beta, while a private equity real estate fund seeks to achieve alpha—and does with strategic business plans for properties and skilled asset managers. Origin’s goal for Fund III is to outperform the market on a risk-adjusted basis and achieve returns well above the index. We focus on finding high quality, underperforming commercial real estate properties that can be turned around. Our philosophy is that this is the best way to protect the downside while maximizing the upside of each deal.
3. REITs are a volatile asset class
When the economy tanks, REITs can get hit hard. “In 2007 and 2008, REITs lost 15.7 percent and 37.7 percent, respectively,” the Wall Street Journal noted recently. Also, since 2000, REITs “are second only to emerging-market stocks as the most volatile asset class. And with interest rates likely to rise, the next few years could be tough,” especially for investors buying REITs now, concluded the WSJ.
4. Funds minimize risk exposure
Our private equity funds are one of the most effective options for investors because they are a diversified investment. At Origin, each of the properties in a fund is run as a separate business. So if one underperforms it doesn’t impact the others. A deal by deal investment strategy does not offer this same benefit.
To better gauge how well Origin’s Fund III will perform, it also helps to look at its other products that have longer track records. Both Fund I and Fund II had projected returns of 17-19 percent, however, Fund I is on track to generate a 28 percent net return and Fund II is on track to deliver a 26 percent return. Preqin, an industry leader that tracks the performance of private equity fund managers, ranked these two funds in the top quartile as of June 2016.
5. Consider the manager’s alignment of interests
According to Towers Watson, a leading global advisory company, co-investment is the most effective way to align the interests of a manager and investors. We started Origin to invest our own capital, and maximizing investment performance remains our primary goal. We continue to keep our skin in the game with Origin Fund III by committing $10 million of our personal capital.
If private equity real estate isn’t part of your portfolio, it needs to be; see our piece on Huffington Post discussing this topic. With its low correlation to other asset classes, high expected returns and low volatility, it scores a trifecta since most asset classes only have one or two of these qualities.