Real estate is one of the oldest and most established investments. Most investors own a home and can appreciate how its value fluctuates based on improvements, market conditions, and supply and demand. It is often a family’s largest single investment.

Real estate investment trusts (REITs) have also emerged as valuable tools in providing growth and income. REITs have become a mainstream response to investors seeking yield in their portfolios or hedges against inflation. However, owning a home or owning publicly traded REITs is very different from investing in private properties.

Private real estate represents a broad and diverse set of opportunities. With roughly $34 trillion in assets under management globally, the U.S. represents 41% of the global market, with growing opportunities in Europe and Asia (27.7% and 23.7%, respectively).

Private real estate has been used primarily by large institutions and family offices because of its historical return, risk, and income profile. According to the CalSTRS 2022 Investment Policy Report, the pension’s real estate allocation is over 15%, above its target policy and higher than its 11% allocation to fixed income, given real estate’s relative attractiveness in the current market environment.

The appeal of private real estate is multi-faceted. Private real estate has historically delivered strong growth and income and diversification relative to traditional investments, and it can help in hedging the impact of inflation. As the data in Figure 1 illustrates, private real estate has delivered strong risk-adjusted returns relative to the S&P 500, other U.S. equities and publicly traded REITs.

What Is Private Real Estate
Private real estate is quite different from its public market equivalents. These properties represent a broad set of global opportunities, which have historically delivered an illiquidity premium—the excess return for tying up capital for an extended period of time. Private real estate has historically provided much higher income than traditional fixed income options and has exhibited relatively low correlation to traditional investments. The last advantage of private real estate is that it can be used to hedge against inflation, in part because of owners’ ability to raise rents to offset it.

Commercial real estate is one of the largest investible asset classes, and the largest category of real assets, representing 90% of the overall market. Over the years, the definition of commercial real estate has varied by investor. We define commercial real estate in the traditional sense—land (developed or undeveloped)—and properties that are used for commerce, business, and multi-tenant dwelling. These properties are leased to tenants to generate regular cash flow, similar to fixed-income investments.

There are four main types of commercial real estate: multifamily/residential, office, industrial/warehouse and retail. Within each type, there are different characteristics, each of which impact how the property type reacts to different market conditions.

Multifamily Properties. These properties are residential buildings with multiple housing units. They can be located in either urban or suburban markets, or be of different style such as high-rise, mid-rise or garden-style apartments, and their quality level can range from class A to class C depending on their condition, location and amenities. In the years following the 2008 financial crisis, some real estate sectors, notably residential, were plagued by underinvestment. Private real estate investors like Blackstone, Clarion and others eventually filled the void and profited handsomely.

Office Properties. Similarly, office properties can be stratified by their location, their number of tenants, and their quality level. Class A buildings are considered the highest quality properties, both in terms of construction and location. They are often prestigious buildings with premium rents. Class B offices are generally of good condition but of lesser quality and/or are in less desirable locations than Class A. They generally compete for a range of corporate tenants with rents that are average for their submarket. Class C office space is typically older and/or in unfavorable locations. These properties generally have below-market rents.

Industrial Real Estate. Industrial real estate encompasses an array of properties where activities such as production, manufacturing, assembly, storage, distribution, and research take place. They are frequently located outside of urban centers close to major transportation routes. There are five main types of industrial properties: heavy manufacturing, light assembly, warehouses, R&D offices, and flex industrial, which is a combination of industrial and office space.

Retail Properties. These properties are spaces used solely for the sale of goods and services. They can encompass the cafes, restaurants, banks, gyms, and shops we frequent and can be single-tenant or multi-tenant. They may be further classified by their size and location.

Other Property Types
Other property types such as senior living facilities, student housing, self-storage and medical offices have also caught the attention of investors over the past decade.

Real estate is considered a cyclical sector where changes in the broader economy impact supply and demand for commercial properties. Yet within the asset class, certain subsectors are more sensitive to the economic cycle than others. Demand for office, hotel, and retail properties often follows changes in economic growth and consumer spending, while demand for multifamily, senior, and student housing is more influenced by population trends.

Investing In Private Real Estate?
There are four main types of real estate investment strategy divided by the condition of properties targeted, level of income generation, and amount of leverage used. Each has its own return, risk, and income profile.

Core strategies have lower risk but also lower return potential. They target stabilized, often fully leased, properties in major markets requiring little improvement with, somewhat counterintuitively, low use of leverage—typically up to 30% of loan-to-value. Returns from these properties are usually in the mid-to-high single digits, derived primarily from rental income rather than capital appreciation.

Core-plus strategies target similar properties but here investors assume an incremental amount of leasing risk, may perform some light renovation, and often utilize greater leverage—typically up to 50% of loan-to-value—to achieve slightly higher returns in the high single to low double digits.

Value-add strategies target properties that are not well-leased (typically with 20% or higher vacancy) and are often in need of renovation or repositioning. Returns from value-add properties are expected to be in the low-to-mid teens, coming from a mix of rental income growth and capital appreciation. Value-add strategies also utilize higher leverage than core and core-plus strategies, typically up to 65% on a loan-to-value basis.

Opportunistic strategies carry the highest risk but also target the highest returns. Often, this involves ground-up development, restructuring or a major repositioning of assets. Returns from opportunistic strategies are expected to be in the high teens, primarily derived from capital appreciation with likely little to no income generation. Opportunistic strategies typically utilize significant leverage, often in excess of 70% of loan-to-value.

Advisors can access private real estate through limited partnerships, non-traded REITs or registered funds (interval and tender-offer funds). Fortunately, in recent years there have been more quality products coming to the market, at lower minimums and with more flexibility features. 

Next Steps . . .
In today’s challenging market environment, advisors need to identify alternative sources of growth and income. They also need to provide diversification relative to traditional investments, and they need to hedge the impact of inflation. Private real estate is uniquely suited to address today’s markets.

Advisors should evaluate which of their clients would benefit from an allocation to private real estate, what funds they have access to, and then revisit their process for allocating capital.

Advisors should determine each client’s goals and objectives, risk profile and time horizon. They should then determine which fund an investor is eligible to invest in based on their wealth (whether the client is a qualified purchaser, accredited investor or sub-accredited investor). Lastly, the advisor should determine the target allocation for the asset class.

Tony Davidow is founder and president of T. Davidow Consulting, LLC, and the author of Goals-Based Investing: A Visionary Framework for Wealth Management, McGraw-Hill, 2021.