The current market environment has pushed family offices to look beyond the traditional asset classes of bonds and stocks. In the ever-present search for higher total returns with predictable cash flows, family offices have been expanding portfolio allocations toward higher-yielding alternatives and, in particular, real estate. This makes intuitive sense, as even in today’s pricey environment, cap rates are hovering above 6.0 percent, a healthy premium over the current dividend yield of 1.8 percent on the S&P 500. More than 560 family offices are either considering or currently investing in real estate, with a current or planned real estate allocation ranging from $5 million to more than $1 billion.
While family offices have always had real estate allocations within their portfolios, their exposure to the asset class has accelerated over the past five years. Despite a decline in real estate deal activity during the past year (which is consistent with the real estate industry as a whole, as asset pricing has driven volume downward), postrecession acquisition activity by family offices has averaged $4 billion per year since 2012, about double the prerecession average of $2.1 billion per year. Similarly, the postrecession annual peak acquisition volume of $6.1 billion is well above the prerecession peak of $4.0 billion.
The long duration of real estate aligns well with the investment objectives of institutional investors, and family offices in particular, which do not require asset liquidity to fund daily operations. The family office real estate investment approach differs, however, from that typically employed by institutional investors. Family offices allocate a greater share of their portfolios to real estate; the average family office portfolio today has about 16 percent in real estate investment, representing the second-largest allocation within their portfolios, after global equities. Compare that with the average Fortune 1000 defined benefit pension plan, which as of year-end 2016 allocated only 3.3 percent to real estate. Family offices are also much more likely to invest directly in real estate. They rightly recognize that, with a certain level of expertise, they can avoid the hefty fees charged by fund managers while achieving greater control and transparency, without sacrificing their net returns. Nearly two-thirds of family offices with assets in excess of $100 million that invest in real estate and are tracked by Preqin invest directly in some form. By comparison, of those private- and public-sector pension plans that invest in real estate, only 30 percent invest directly, instead relying primarily on closed-end commingled funds.
As their portfolios have grown, family offices have been expanding geographically and outside of their home markets, with activity moving into secondary markets. The allocations do vary: International family offices gravitate toward core assets in primary markets. Domestic family offices are more willing to invest in secondary and tertiary markets. Family offices have also been expanding into alternative real estate product types that they have historically not had a large presence in, such as student housing and senior housing. These alternatives offer higher yields than traditional core products. Student housing, for example, typically will trade at a yield premium of 1 percent to 2 percent over a multifamily rental asset in the same market.
As family offices have increased their ability to source real estate transactions directly and created real estate operating companies under their umbrellas, they have realized they can leverage this expertise into raising outside equity capital. Advantages to raising capital from limited partners include greater portfolio breadth and diversification, as well as generating significant fee revenue, both through asset management fees and carried interest. Disadvantages include a lower level of control regarding major decisions associated with properties, as well as increased reporting requirements. We have seen an increase in the number of pitches from family offices attempting to raise capital from institutional investors. These family offices point to their successes and volume of activity in their own proprietary portfolios, with the desire to replicate that success for prospective limited partners. In addition, we have been asked by a number of family offices to help them evaluate the strategies and trade-offs associated with using outside capital.
With the spread of real estate cap rates to fixed-income and equity yields at historical highs, we expect family offices to continue to look for new ways to gain exposure to the sector, and to become an increasingly important capital source for the real estate industry.
Ben Maslan is a principal with RCLCO Real Estate Advisors. RCLCO associate Sevan Douzdjian also contributed to this column.