Large institutional investors have always allocated a percentage of their assets to real estate. This asset class provides diversification, it can be an effective hedge against inflation and its performance does not correlate with the stock market.
But it's tricky for family offices and similar entities to decide what type of real estate belongs in their portfolios, where it's critical to balance risk with return.
The best risk-adjusted returns available today often come from income-producing real estate. These investments combine relatively high and predictable current income streams with a great degree of principal safety, factors that would make them attractive to high-net-worth individuals.
Equity Real Estate: Investment Strategies
Generally, the industry uses the following fund classifications to describe real estate's key risk/reward characteristics.
Core Plus: This is a moderate risk/moderate return strategy. A core-plus fund will generally invest in properties in metropolitan areas, usually established office buildings and retail properties that are among the best in a given market. Some of these holdings might need enhancements. This is a buy-and-hold strategy, with uncertain and variable cash flow for investors during the holding period.
Value Added: A value-added fund will purchase what it considers to be undervalued properties at the right price-properties with management or operations problems, a weak mix of tenants, or properties that might require physical upgrades.
The sponsor believes it can manage the properties more efficiently, reduce operating expenses, make physical improvements, reposition the assets in their markets, seek out new tenants and ultimately increase rents (and thus property values) over time. If it can successfully increase value, the sponsor would then sell at an opportune time, generating what could be a significant capital gain for its investors. There is typically little or no cash distributed to investors in the early years.
This is a buy-low, sell-high strategy, characterized by medium-to-high risk and anticipated medium-to-high returns.
Opportunistic: This is a high-risk/high-return strategy, a value-added fund on steroids. These funds target distressed properties that need lots of improvement, but also attempt to take advantage of distressed owners unable to refinance maturing mortgages or in difficult financial straits for some other reason. Those factors allow the funds to purchase performing assets at bargain prices. Opportunistic funds often invest in incomplete new developments and niche property sectors. Management will often make extensive physical improvements to the assets, change and optimize the tenant mix and frequently build additional structures and replace existing ones as part of its strategy.
As they do in value-added funds, investors here make money when the investment manager buys the right asset at the best possible price (these are often referred to as "vulture funds.") The manager must successfully execute an often complex strategy where there is little room for error, and then sell into a better real estate market in the future. Opportunistic funds rarely distribute cash to investors; virtually all of the benefits come when the properties are sold.
The success of equity real estate investments depends on the ability of the investment managers to execute their acquisition, management and disposition strategies in a timely manner. Success also depends on a variety of significant unknowns, primarily future interest rates and real estate values and capitalization rates.
Chasing Yield
Income-Oriented Real Estate Debt Funds: These funds offer mezzanine loans and similar mortgages to generate current income. There is a huge demand for such debt capital today, since billions of dollars of mortgages need to be refinanced over the next few years, yet there is only limited mortgage financing available because of the more stringent underwriting policies by primary lenders and today's more realistic property values. A debt fund worth considering will make loans against well-located commercial properties with good tenants based on today's value, after having done extensive underwriting and due diligence. Investor cash flow comes from the borrower/owner's regular mortgage payments, and the original principal will be returned when the borrower sells or refinances the property.
Technically, debt funds are not considered "core" assets, but a fund that is well structured and well managed has the same moderate risk/moderate return characteristics a core plus investment does. Unlike equity funds, debt funds offer no capital appreciation; instead they feature predictable current income, generally in the range of 9% to 11% annually. In our view, therefore, a well-structured debt fund is a reasonable, income-oriented alternative to traditional core-plus equity funds.
Net-Lease Funds: These funds acquire assets subject to long-term leases on properties with single or multiple corporate tenants, where the lessee typically pays all of the operating expenses. Such funds generate current income and could see some capital appreciation. The success of a net-lease fund relies on the predictability of the lease payments to generate distributable cash for investors.
These are income-oriented investments, generally considered to be in the core-plus category, with moderate risk and moderate return. A net-lease fund with the following characteristics, however, can reduce investor risk and increase the certainty of current returns:
1. If it acquires only operationally significant assets net leased on a long-term basis (usually 12 to 15 years) to investment-grade or creditworthy companies.
2. If it acquires only assets leased to single tenants.
3. If almost all of its acquisitions are off-market, private transactions. This acquisition technique enables a fund to buy assets at lower-than-market prices.
4. If many of the acquisitions are "build-to-suit" transactions, where the investment manager is often contacted directly by the corporation and thus is involved from the outset, negotiating the lease with the corporate tenant, finding a suitable developer, and arranging construction financing. Funds that do this can share in the developer's profit for an even greater acquisition price advantage.
The creditworthiness of the corporate tenants in this type of fund sets it apart from the other real estate investment strategies because there is virtually no risk that a corporate tenant would jeopardize its credit rating by walking away from the lease. In that respect, a net lease is much like a corporate bond: An investor can buy a Federal Express ("BBB" credit) corporate bond maturing in 2014 with a yield to maturity of 2.53%, or a Federal Express net lease, backed by the same credit, that generates 6%-8% annual cash flow, depending on the amount of leverage used, and also has the potential for capital appreciation.
Again, a well-structured, well-managed net-lease fund has the risk profile of a core investment (low risk) combined with the return profile of a core-plus investment (moderate return). Primarily because of the investment-grade nature of the lessees, these factors significantly mitigate investment risk:
1. There is no lease-up risk. The corporate tenant has executed the lease before the acquisition.
2. There is no vacancy risk. These properties are operationally significant and mission-critical to the lessee.
3. Because the operating expenses are borne by the tenant, there is no expense risk.
4. Because of the tenants' creditworthiness, construction and mortgage financing are readily available at favorable terms.
5. Investment holding periods are usually shorter than they are in other real estate investments.
6. For the family office or a similar investor, there is a certainty of cash flow from the outset.
A properly structured net-lease fund offers investors the best risk-adjusted returns available in real estate today. Family offices and similar investors looking for a conservative, income-producing investment with low risk but moderate returns, one with no correlation to the performance of the stock market, ought to consider income-producing net-lease funds for a portion of their assets.
David Wrubel has been involved in real estate and financial services for over 27 years. His company, D2 Advisors, provides consulting and capital markets advisory services to both national and regional real estate fund managers, operating companies and developers.