Publications

- May 1, 2018: Vol. 5, Number 5

Alternatives in bloom: The menu of offerings expands as investor demand grows

by Joseph Dobrian

A parade of new products is coming to the alternative investments market, giving individual investors greater access to real asset classes. Some of those products are grabbing the attention of private wealth advisory firms, as well as the general public. Private equity, hedge funds, managed futures, hard real estate assets, commodities and derivatives contracts all have their adherents. Today, nontraded REITs, preferred stock, private credit funds and interval funds seem to be gaining popularity. So does private placement of capital in individual assets, as well as investment in non-glamorous categories such as student and workforce housing.

“Versatility” appears to be a key word for asset managers, broker/dealers, or anyone who offers the opportunity to invest directly or indirectly in real estate. A greater variety of investment vehicles is available now than in previous cycles. This is important as investors become more mindful of portfolio-
diversifying investments, in anticipation of a market correction and perhaps a new business cycle.

Niche plays are gaining favor, as well. Investment professionals are looking for unusual, almost surgical opportunities, in a market where conventional core investments are producing unexciting returns. One problem, of course, is that if an investor makes a successful play, others will imitate — and very quickly, that play is old news and no longer hot.

For example, Nina Streeter, director of asset management for Boston-based Abbot Downing, reports that she noted three airplane funds being raised in the same week, which makes her concerned that upward pricing pressure might lead to disappointing returns in that niche.

“These sudden bursts of interest all result from the same problem,” she says. “When major governments print excessive amounts of cash, it causes upward price pressure in assets. Regular investors in core assets then start looking at the niche areas. This might mean new, marginal money coming from less experienced players, and over time, that could drive down returns in those niches. You will find great managers in all sectors, but they cannot control or change the pricing dynamics.”

Streeter says she sees many real estate firms focusing on student housing, senior housing, medical offices and other specialized plays. Mining in general has gained popularity, with prices still more reasonable than in many other sectors. Farmland, water and timber plays appear less attractive, although she notes that water infrastructure is slowly eroding all over the world, and will need billions of dollars for modernization. Some investments around water rights might bear looking into, although odd use requirements, pricing and legal structures make this sector challenging. She feels it is “frightening” how little has been invested in water infrastructure: the difficulty lies in making a good return on it.

While traded REITs remain popular with many asset managers, some players are gravitating away from traded products, or have never worked with them. REITs tend to trade with the market, although their share prices are often more volatile than the S&P 500 index. Their dividends tend to be modest, and investors pay a premium for their liquidity. Many investors in traded REITs are currently feeling whipsawed by the volatility of the market, and are looking for investments that don’t move around — physically or price-wise.

On the other hand, nontraded REITs cannot be very liquid if they are to maintain their portfolio. They come with lower fees, and with an expectation of a long-term hold. Some asset managers are currently looking to set up perpetual-type nontraded REITs that will offer greater liquidity; they are also working more with private placement of capital in general or limited partnerships — in large debt funds, or in single-asset opportunities. These options appeal to sophisticated investors who have insights into specific markets and property types, who are keen judges of risk (and their own capacity for it) and who are looking for additional output from smaller allocations. Asset managers are responding to investors’ demands for more choice, using structures that fall within their company’s areas of specialization.

ALTERNATIVES TO CONSIDER

Another company offering investors an alternative to publicly traded common stock is Atlanta-based Preferred Capital Securities. Al Haworth, the company’s CEO, says he doesn’t regard the preferred stock his company offers as an “alternative investment,” adding that preferred stocks have the same transparency as all of Preferred’s SEC filings. This preferred stock cannot be compared to a nontraded REIT, because while neither is traded, listed, or rated, preferreds offer daily liquidity — and they are deemed equity, not debt as most traded preferred stocks are, on Preferred’s balance sheet. Preferred favors multifamily as its core investment, with some commitments to student housing, grocery-anchored shopping centers and office properties.

“This gives you a line of predictability to getting your principal back,” he explains. “You get ‘mailbox money’ every month. This is a coupon, not a yield. Stated value is $1,000 per unit, five units being our minimum investment. In a world of 2 to 3 percent returns, we can do a little better.”

Preferred’s preferred stock is a bond substitute, and loses nothing to fees. It has no maturity date, nor a date when it will be taken public. It is typically part of a fixed-income portfolio, without the volatility of the underlying security.

Private credit funds are currently the big story, according to Carol Womack, principal and head of private equity in the Nashville office of Diversified Trust. She reports that assets managed by private credit funds have tripled in the past five years, due to investors’ desire to combine safety with improved returns. She expects secondary transactions to continue to increase in volume and value, with more trades at par and fewer expectations of discounts. She is astonished by the rise of mega-funds — in particular SoftBank’s $98 billion Vision Fund — but is not a fan, so far.

“We had thought the Apollo Fund was incredible, at just over $24 billion,” she recalls. “It remains to be seen how efficiently SoftBank can deploy that much capital. That’s a lot of money to put to work, and some investments may end badly. The increase in the size of those funds is crossing over into venture capital funds, which may be a concern. One emerging theme in their investments is artificial intelligence, not just the development of technology, but the applications of it, in robotics, etc. Blockchain technology may become more important.”

However, Womack adds, investors seem to be backing away from real estate because the market is so fully priced that opportunistic plays are hard to find. But significant pockets of opportunity still exist, she adds, and by taking advantage of them, instead of taking a “core” approach, investors still could realize mid-teen returns. As need grows for storage and logistics space, industrial real estate may become more attractive.

Interval funds have been gaining investors’ attention, although some investment experts note that they are still untested by a serious down market. Alan Feldman, CEO of Resource America, a New York City–based asset management company, notes that his company and the industry as a whole have seen strong demand for interval funds. The interval fund structure, he explains, allows portfolio management to access both public and private real estate investment opportunities, thus offering retail players an institutional-quality investment. These funds, he says, offer quarterly liquidity; daily, transparent pricing; and general real estate investment benefits such as income, diversification and low to moderate correlation with the broader equity market.

“Investors should always be informed through research on what these opportunities mean for them,” he warns. “They should understand the underlying assets the fund invests in, the terms of the fund, and how and when can they redeem their investments. Interval funds and other alternative investments provide the returns and diversification necessary to a well-balanced portfolio, but investors must understand exactly what they are investing in.”

Darren Whissen, founder and president of Atomi Financial Group in Irvine, Calif., agrees that investors show enthusiasm for interval funds, since they are transparent and easy to buy into, but he wonders how they would perform if market conditions trigger a flight to liquidity.

“They generally operate on lines of credit,” he points out, “which is okay in a stable environment, but what if we have a market bloodbath? Only after they are tested in a severe down market can we know interval funds’ true correlation to the stock market.”

FINDING YOUR NICHE

In terms of real estate asset classes, Whissen is enthusiastic about student housing and self-storage. From a structure standpoint, he sees a push for fee-only illiquid investments. He observes more products coming in with no front-end internal load, so that they look like a hedge fund, but the asset management fee will not kick in until the client has earned a certain return.

More RIAs are adopting alternative investments, he notes, and are getting away from the standard 60/40 stock/bond portfolio. On average, 50 percent of his clients’ investments are now in alternatives: generally less liquid than stocks but with completely different risk profiles.

Student housing, Whissen points out, is becoming more upscale, and demand is growing for modern product. It promises 90 to 100 percent occupancy every year, plus 90 to 100 percent turnover, making rents easily adjustable. Student housing is a great alternative, he says, for those who want to get into real estate but are afraid that cap rates in multifamily are too compressed. Student housing is especially attractive to 1031 exchange buyers.

Self-storage, too, is having a renaissance. It is a highly fragmented industry, with the big publicly traded storage players still only representing a small percentage of the market. Leases tend to be short, so owners can raise rents frequently.

Demand is also high for workforce housing — apartments for tenants who have steady paying jobs but are on a tight budget — and developers are looking for urban infill locations where they can provide it. Brian DeLucia, managing partner at New York City–based Arrivato, a family-run developer, says his firm has been acquiring land and constructing garden- or townhouse-style apartments. He points out that class A multifamily is bubbling in many markets, with rents pushing toward the breaking point, and traditional value-add class C properties have become overpriced, reducing the upside and the margin for error. Workforce housing is especially in demand in the southeastern states, and larger cities need quality affordable housing.

“High-net-worth investors will be interested in developments of 200 to 400 units of workforce and affordable housing,” he predicts, “and you will find institutional investors looking at larger developments. There is a good three-year run in that space, in some markets, and if you buy correctly you should realize yields north of 10 percent.”

Value-add class C multifamily strikes DeLucia as too risky. Cap rates in that segment were in the 7 to 7.5 percent range a few years ago. Now they are 5.5 percent with too much reliance on steady rental increases — at a time when many tenants are already stretched by their other expenses. However, he is enthusiastic about repurposing older assets for student or affordable housing. Single-tenant site development for consumer-generated retail is another attractive alternative.

Another multifamily specialist, Scott Lawlor, CEO of Waypoint Residential in Boca Raton, Fla., typically avoids the center of the fairway in areas where the competition for buying assets can be “utterly brutal.” He agrees with DeLucia that the value-add segment can be too risky for the returns it offers.

Waypoint hopes to team up with senior lenders to support a piece of a loan to other developers. By offering to buy the lowest 20 percent in an 80 percent loan, they enter the deal on the origination side, rather than offering mezzanine or preferred debt.

On the whole, Lawlor admits, multifamily rent growth is slowing because of increased supply, but he insists that national statistics are irrelevant. Serious oversupply exists only in a handful of markets where capital congregates.

“Developers are competing to offer the sexiest, shiniest product at the highest price points,” he says, “but that is not where many households are formed. If you can pick your spots, as we do, you can stay busy even if we might be in a more mature part of the cycle.”

As noted, investors have a growing menu of alternatives when considering alternative investments. The key is finding attractive offerings that meet their respective risk profile and investment objectives.

Joseph Dobrian (jdobrian@aol.com) is a freelance writer based in Iowa City.

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