With the risk of rising inflation threatening to erode real purchasing power and no opportunity for meaningful returns on fixed income securities, the opportunity for return on cash would seem to lie solely with riskier assets, like public equities. Simply put, investors searching for returns are moving into the stock market.

This can be a challenge, however, for individual investors, particularly those nearing retirement age, as well as for large institutional investors whose commitments to stakeholders rise with inflation. Importantly, institutions need to earn ahead of inflation if they are to keep pace while still operating within appropriate risk parameters.

But large institutions have a few tools in their arsenals that individual investors typically don’t.

For starters, they generally operate on very long investment horizons, freeing them to invest in less liquid, and potentially higher yielding, assets.  Not surprisingly, over the past 40 years defined benefit plans have allocated roughly 5 percent - 10 percent of their assets to direct real estate investments according to JP Morgan. Between 80 percent and 90percent of that real estate allocation is in private market assets, which can provide meaningful total returns through a mix of appreciation and current income, both.

Real Estate And Inflation
With very few exceptions, private real estate performance has remained highly correlated to the Consumer Price Index (CPI) over the past 30 years, making it a good inflation hedge across long periods of time. The exceptions, and they are usually predictable, typically occur when real estate prices overheat as they did in the early 1990s and 2007. The chart below, which tracks the NCREIF National Property Index (a total return index that tracks the performance of investment grade commercial real estate) relative to the consumer price index illustrates the pattern.  As indicated, real estate performance generally tracked inflation most of the time since 1980, with exceptions in 1991 and 2008.  Moving out of the recession, we see that real estate prices have corrected and real estate is once again tracking the CPI.

In addition to providing a hedge against inflation, private real estate can also generate relatively high levels of current income. Where long term investors in public equities often need to ‘sell’ some assets (a taxable event) to generate cash to cover obligations, private real estate can generate cash flow without the need to sell, providing an opportunity for investors to get inflation-protected yield without having to dispose of the underlying asset.

The ‘Illiquidity Premium’
For institutions, private real estate investments also offer an added advantage in that they provide an opportunity to capture what is sometimes called an “illiquidity premium.” This is the difference in returns or yields that investors demand to hold assets with lower levels of liquidity. The more cumbersome and time consuming it is to sell an asset at the market price, the higher the expected return, holding all else constant.  Large institutions, which are not likely to sell quickly, often choose to take long term exposure to capture the illiquidity premiums and enhance returns.  In the case of income-producing assets (such as real estate and private equity), the illiquidity premium is often expressed as a higher current income yield and/or higher expected return over the more liquid (often publically traded) counterpart.

So What’s A Smaller Investor To Do?
Publicly traded REITS do offer some appealing real estate exposure to smaller investors who can afford neither the minimum investments required by many private transactions, nor the lack of access to their cash. But it’s important to remember that performance of many publicly traded REITs is highly correlated with the broader equity markets, which means that some of the diversification advantages of investing in real estate are lost.

There are also an emerging range of hybrid options for smaller investors. Among these are interval funds, which provide liquidity at regular intervals (but not daily). These funds are able to invest in less liquid assets such as private real estate, giving investors some of the opportunity to capture an illiquidity premium as well as some inflation protection and yield, while still meeting smaller investors’ need for redemptions. If well managed, these can be a very interesting alternative. Importantly, for these funds to best capture the illiquidity premium, they should be invested primarily in direct real estate and not in other publicly traded REITS.

Some Added Benefits…
While private real estate’s popularity is attributable both to its potential as a hedge against future inflation as well as its ability to deliver relatively high current yields, there are other benefits to private real estate as well. For starters, private real estate may provide yield with tax savings derived from depreciation allowances, and tax advantaged entities such as REITs, do not pay corporate income taxes as most public equities do.

For investors worried about both inflation and rising taxes, it may be worthwhile looking beyond the broader equity markets to real estate or similar, less liquid, current income-generating assets. If properly structured, they can potentially provide not only yield, but also needed tax advantages.

Randy Anderson, Ph.D.  is President of Bluerock, a professional asset management firm in the alternative investment space. An investor and academic in the real estate industry for more than 20 years, Dr. Anderson is responsible for strategic management at Bluerock. He also serves as Portfolio Manager for the company’s recently-launched, Total Income Plus Fund of Funds.