Real estate is one of the most diverse asset classes and the diversity within the asset class extends to the range of investment vehicles open to family offices. Fixed income investments and listed equities require little continued involvement after purchase save for continued evaluation, strategising, and adjusting allocations. The bar is higher for real estate. Directly investing in real estate requires analytic and due diligence work and then the continued management of properties after purchase. Operating a real estate portfolio often requires forming a separate management company making this investment path the same as starting any new business as the active management of a property portfolio requires expertise, personnel, and capacity. This leads some family offices to work with partners with real estate as their core competency or to invest in real estate through funds.
It can be difficult for family offices looking to diversify their assets into real estate to compare their options. This article pulls together some “back of the envelope” calculations to help jumpstart internal conversations about real estate investing.
Real Estate Funds
Not all funds are equal, but best-in-class investment funds bring to the table the knowledge and capacity to execute winning strategies. They also charge significant fees for access to their expertise. For years, the standard fee structure of funds was “two and twenty.” That is 2% AUM as an annual fee and 20% of the profit. Usually, a minimum profit, often around 7%, had to be reached before the fund managers collected their 20%. High water marks might also be required for fund managers to collect their fees.
TOTAL FEES =20% OF PROFITS + 2% OF TOTAL ASSETS
There is evidence of downward pressure on investment fund fees and of a movement away from them together towards the less costly alternatives of private equity and passive investments.
HFR reported that hedge fund fees on average stood at a 1.4% management fee and 16.4% performance fee in the fourth quarter of 2020. A working paper published by Ohio State University examined hedge fund performance fees, finding that the “aggregate effective incentive fee rate” averaged around 50% rather than the 20% contractual rate. The authors attribute this result to the inability of investors to “offset gains and losses across funds, and that entry and exit decisions of investors and managers are path-dependent and tend to undermine the effectiveness of high-water mark provisions by destroying fee credits.” Another cause is applicable to all asset classes and investment vehicles, that is the prevalence of “return-chasing behaviour” that leads people to invest in a fund after it shows strong performance and withdrawing after declines.
Real estate funds are different animals, but the long-accepted fee structure is being questioned, even challenged, and the behavioural findings are a point of caution for all investors.
The focus and strategies of real estate funds vary considerably. Large institutional investors most often look for a steady yield without managerial responsibility. This might be an attractive route for family offices looking to preserve wealth and diversify assets through conservative investing strategies. Funds and other real estate investors often concentrate their holdings into the pre-defined risk profiles of core, core+, value-add, and opportunistic. They may aim for diversity or target niche market sectors where they have identified growth opportunities.
In sum, real estate funds may open strong value propositions with promising investment theses to family offices, but the fees can be high.
Direct Investments
Directly investing in real estate requires either that family offices shoulder the burden of the entire endeavour or work with investment managers and contract out property management and operations. The key considerations are identifying prospective investments, financing, and operations after purchase. This can be a daunting task even if the plan is to partner with a property management firm. It ties up capital, even if the investment is leveraged at a 60/40 ratio, and depending on the family office’s level of commitment to the asset class, it might be difficult to diversify real estate holdings enough to de-risk a property portfolio. That said, the number of family offices that are deep into real estate are prime examples of the growth and security available in the asset class with the right operational knowledge and capacity.
Property management companies typically charge between 5% and 12% of leases. Maintenance fees are an additional expense as would be any further potential value-add investments into the property. Cost control and predictability are difficult without effective management. A common leveraging strategy assumes 60% debt and 40% capital for the property. Increasing interests may lead to increased capital demands to maintain profitability in the investment.
Co-investments
Co-investing is a way to benefit from an investment fund’s expertise and capabilities, but with reduced fees. In real estate, co-investments take three main forms:
Sidecar co-investment:
A sidecar co-investment is when the fund manager solicits additional capital from the entities currently enrolled in the fund to make a separate investment. Buy-in rights and investment priority differ between funds.
Pre-arranged co-investment:
Fund managers and investors can negotiate co-investments terms at the point of fund subscription in case the opportunity arises.
Outside co-investment:
Fund managers may open co-investment opportunities to investors outside of the fund.
Co-investments can be negotiated before buying into a fund or arise at a later date, possibly toward the end of the lifecycle of the fund. Each type brings distinct opportunities and risks.
REITs
Publicly traded REITs often trade correlated with other listed equities and may provide similar exposure to some large listed asset management companies with a large proportion of real estate in their portfolios. The investment decision hinges on standard due diligence, buying low, and selling high, if there are no dividends. The investor exercises no control over the underlying assets.
We’ll leave co-investing and REITs out of the discussion that follows to focus on comparing real estate funds and direct investments.
Conversation Starter
The key decision family offices interested in investing in real estate need to make is whether to go direct (possibly by partnering with other FOs or management firms) or to invest through funds. It is always difficult to compare like for like and create accurate cost projections. Below are some rough estimates of the costs/fees and potential gains of both routes. The potential gains, especially for funds, are on the optimistic side to be sure, but not out of line with what some funds include in their investor material.
The goal is to jump-start internal conversations about the role of real estate in your family office portfolio and the potential routes to exposure to the asset class.
The model below assumes a real estate fund with a 2 and 20 structure paid annually with a targeted 15% annual return. The direct investment example assumes a 60/40 debt-cash ratio at an interest rate of 5%. Lease income is estimated at 5% of the property value with property management contracted at 8% of leases and a property value increase of 5% per year. Taxes are left out as they differ between jurisdictions as are transaction fees.
The numbers are per 1.000.000 € invested.
These rough and ready comparisons illustrate two different routes to potential gains in real estate. Investors put their trust in the strategies of fund managers for targeted risk-adjusted returns, while they assume the full burden of direct property investments. The number of potential variables is difficult to control and overly optimistic projections are many, making it all the more necessary to evaluate prospective investments across different outcomes and market conditions.
Funds provide exposure to real estate for FOs that prefer a less capacity-intensive approach than direct investing. Potential upsides with funds are potentially strong returns that may be more diversified and de-risked, depending on the fund strategy, than direct investments owing to their higher AUM. Depending on the level of commitment to the asset class, a directly owned real estate portfolio might be difficult to diversify. The high fund fees that investors are paying for capacity and expertise might bring greater investor returns than direct investments if the fund’s targeted projections are reached. A fund’s potential to reach its projected returns is what investor due diligence must ascertain. Many do not.
Two points of profit potential in direct real estate investments are during property transactions and through management. Fluctuations in property markets at the point of purchase and sale, in addition to operations and maintenance costs which tend to increase the longer the property is owned, factor strongly into investment outcomes. There is significant space for family offices to optimise their property management operations to increase value, but this takes further investing to build out capacity. A family’s ability to make the most of their patient capital will provide a buffer for market fluctuations. Direct ownership of property also, often, retains value over the long term.
In the end, when you’re sitting around the table with key decision-makers and asset managers considering investment strategies, it can be helpful to ask yourself “why am I special?” That is to say, if the fund’s strategy is so promising, then why isn’t it oversubscribed? Why is that piece of commercial property still on the market? What acumen in identifying and managing property does my family office have that others do not? What would my fund investment look like if it meets the hurdle rate, but only just? Do we have liquidity elsewhere to hold a direct property investment through a market downturn? What about the loss of our tenants for an extended period of time?
Answering these questions should be a good check on overly optimistic assessments of the proposed opportunity before you.