Private real estate plays a significant role in institutional investor portfolios, representing 10 percent of their total assets on average according to the 2019 PREA Investor Intentions Survey, with the majority in core real estate. Conversely, though, I have found that investment advisers haven’t historically included core real estate in high-net-worth client portfolios. However, that could and should be changing.
Core real estate assets are generally defined as class A properties located in primary markets that are well-occupied by creditworthy tenants with long-term leases. Unlike many non-traded REITs in the market today, core strategies employ modest leverage – typically in the range of 20 to 25 percent loan-to-value. Core real estate is considered a conservative, income-driven investment strategy, with income accounting for about two-thirds of total returns on average and capital appreciation accounting for the remainder of returns in the NFI-ODCE core real estate index over the 20-year period ending in September 2019. The stability of income has had a smoothing effect on the overall volatility of returns.
Factors that previously have discouraged advisers from pursuing core real estate included concerns about overexposure to real estate given their clients’ personal property holdings, the tax burden associated with a yield-centric asset class and lack of adviser access to institutional-quality investment solutions. But we believe evolving trends in the economy and property markets, new tax policy and the growing availability of private real estate investment solutions make it a good time for advisers to consider the potential benefits of adding core real estate to high-net-worth client portfolios.
CORE REAL ESTATE AS AN ASSET CLASS
Core real estate provides investors with systematic exposure to economic drivers and property trends prevalent in the nation’s largest cities — exposure that cannot be achieved with personal property holdings. Three primary attributes differentiate core real estate from personal property holdings:
- A core real estate portfolio is a set of prime properties that achieves diversification by the number and types of properties, geography and tenant mix. Data analyzed by CBRE Global Investors in 2017 found that an investor needs to hold 32 properties to reduce 95 percent of the idiosyncratic risk in a real estate portfolio.
- Core real estate returns are correlated to economic drivers in major markets. Exposure to major cities has benefited investors given the divergence in economic growth between large and small cities since the financial crisis. Powered by well-educated millennial workers and agglomerative trends driven by digital technology, large markets are growing faster and accounting for more of the national GDP.
- Core real estate is a dynamic asset class with portfolios that can adapt over time to reflect the evolving economy, demographic changes and the different ways people are using real estate. Technological advancements and demographic trends are increasingly changing lifestyles, work patterns and consumer behavior. Core strategies can adjust to structural changes by investing in properties that reflect the new ways tenants are living, working and consuming.
CORE REAL ESTATE IN PORTFOLIO CONTEXT
Core real estate offers four potential benefits within an asset allocation.
Strong and stable income: Long-term leases with creditworthy tenants provide predictable income. Over the past 20 years ending in September 2019 core real estate – as defined by the NFI-ODCE – has produced an annualized income return of about 6.0 percent.
Attractive risk-adjusted returns: The NFI-ODCE has produced high risk-adjusted returns over the same 20-year period, which has the effect of improving the efficiency of portfolios.
Inflation-hedging attributes: Land values and rents typically rise with inflation, and because of that, real estate can provide a partial long-term hedge against inflation.
Diversification: The NFI-ODCE has had a low correlation with equities and a slightly negative correlation with bonds over the past 20 years.
Recent tax changes can make private real estate funds more tax efficient by allowing a deduction of income from pass-through entities like those commonly used in private real estate funds. Private U.S. real estate funds are often formed as Delaware limited partnerships, which may hold U.S. real estate assets in a private REIT for potential tax efficiencies.
The Tax Cuts and Jobs Act of 2017 introduced several measures that affect REIT taxation and may offer potential tax benefits for investors in private real estate funds. The act generally allows a deduction for non-corporate shareholders equal to 20 percent of certain income from pass-through entities, including ordinary dividends distributed from a REIT. The result is an effective federal income tax rate applicable to REIT income of 29.6 percent — compared to 37 percent — for a taxpayer in the highest tax bracket.
ACCESS TO INVESTMENT PROGRAMS
Many institutional investors gain exposure to private core real estate by investing in one or more of the funds included in the NFI-ODCE, which is a composite index of 24 open-ended commingled funds pursuing a U.S. core real estate investment strategy. Funds in the NFI-ODCE are infinite-life private investment vehicles available to qualified purchasers that offer investors the ability to enter or exit on a periodic basis (typically quarterly), subject to subscription and/or redemption requests.
Advancements in financial intermediation now are allowing institutional investment managers to provide advisers access to private funds at low investment minimums. We are seeing an increasing number of advisers adopting technology-based alternative investment platforms that allow investors to gain access to private equity real estate strategies that had previously been available only to institutional investors.
All of these factors provide advisers new opportunities to give their high-net-worth clients access to the benefits of private core real estate.
Scott Spalding is the head of high-net-worth private markets for CBRE Global Investors.