Planners and wealth managers considering adding private equity to their accredited high-net-worth clients' portfolios may achieve higher total returns by making a private equity allocation in certain business sectors that are benefiting from demographic shifts and changes in the economy. Expectations, however, should not be pegged to some of the dramatic performance returns seen elsewhere, such as those publicly reported by the Washington State Investment Board.
Even in this recently tempestuous market, several major leading-edge pension fund managers such as the Washington board, which has $68 billion, have been allocating a larger portion of their funds' assets to private equities. Washington state recently boosted its private equity target allocation from 17% of assets to 25%. The Oregon Public Employees and the Pennsylvania State Employees Retirement Systems are the next most aggressive at 14%.
The dodgy stock and bond markets, which until quite recently were close to trading at all-time low yields, are typically the reasons offered when planners and wealth managers begin to consider exchanging some of the liquidity of public securities for what they hope will be the higher yields of private equity placements.
Any private investment the portfolio manager might consider will necessarily involve the cost of a reduction of liquidity. As a result, the analyst will need to believe he's getting something in yield or total return that he has reasonable confidence will outperform the opportunities available in the public sector. Financial analysis is ultimately based on supply and demand, and the analyst needs to focus on demand drivers he can understand and believe in, and to find sponsors and managers who know how to deliver results in the real world. Considering this, there are specific investment areas he might want to consider.
Upper-End Extended-Stay Hotels
Well-selected, upper-end extended stay hotels offer interesting opportunities for patient, yield-driven investors. Here, private market yields of 8% to 10% can be found, featuring growing but well-regarded brands such as Hilton's Homewood Suites and Marriott's Residence Inns. Business travelers who may be in town for a few days like the larger rooms and high-tech amenities these brands offer. They like the free breakfasts they can get easily in the morning. After that, they typically prefer making their own meals or dining out in local restaurants rather than the usual food available in most full-service chain hotels.
Once the residence hotels have been developed and rented, there has been a ready market for a takeout or purchase by the better hotel REITs. Direct investment in those same REITs, though, have been hurt by increased volatility-and from yields that are 300 basis points lower than what the private placement market has been providing, if not more. When considering a private placement in this sector, look for newer or better quality to-be-developed properties. There are older hotels in the world-The Plaza in New York or The Ritz in Paris-that look wonderful after one hundred years, but few properties built in the last 30 had that kind of design or craftsmanship. By the time even a good quality franchise property is 30 years old in the U.S., it typically has been renovated two or three times already and there's not much one can do to upgrade it enough that it would compete for business travelers with larger rooms, free Wi-Fi, full services for electronics and a free breakfast buffet. The old services a good business hotel used to offer (a restaurant, a shoeshine, a barbershop, etc.) are only provided today in four- or five-star hotels, and not in all of them. Convenient parking near an interstate highway or an airport will attract more business travel today, but a new Hilton Homewood Suites with free parking and larger rooms can often smoke the performance of a 25-year-old "full-service" suburban Hilton.
The private market investor would like to believe that when his property is fully complete and marketed it will sell to a hotel REIT at a cap rate in the 7%-8% range. Even if the analyst has faith in the demand, investors should take care. It is critical to look for experienced operators, transactions where there is some real shared motivations between the sponsor, the manager and the investor, and where the properties are themselves not overleveraged.
Private Student Housing
The bright spot of private student housing is worth a look by planners and wealth managers who will consider an alternative niche play to keep their clients fully invested in the real estate portion of their portfolio. Well-managed private student residences built by companies with strong records and expertise could increase an investor's yield, reduce the volatility of his real estate portfolio, and even, perhaps, increase the typical internal rate of return of a real estate play.
There are reasons for this optimism. In the last five to ten years, the housing product that attracts students has evolved. Far more of the student housing put on line has been single-student bedrooms, in suites and apartments, most with private bathrooms and many with fully equipped kitchens.
Cash-strapped universities have focused their own resources on improving faculty and classrooms, but increasingly turned to private real estate developers for a number of benefits: off-balance-sheet and off-credit financing with no contributions or guarantees from the school; turnkey development services that relieve the universities' typically overburdened administrative staff; expedited development and delivery schedules; more innovative and market-driven designs and amenities; and lower costs that provide reasonable rental rates for self-supporting projects.