Why private commercial real estate is built to last
This year, family offices put 27.1% of their portfolio investments into public equities.
During the same period, real estate investments dropped to 16.2% of the average portfolio, down 0.7% from a year earlier. Further analysis by UBS and Campden Research concludes that the increased popularity of public equities is due in large part to advisors' efforts to quickly offset losses sustained in 2015.
Because public markets are more widely accessible than private and offer a greater level of liquidity, it is also likely that many family office advisors made the move to stock investments as a means of ensuring that funds could be released whenever necessary and made available for rapid shifts in strategy. However, considering the volatility of the public equity market, investing in stocks over commercial real estate is a high-risk strategy with the potential to result in heavy portfolio losses over the long term.
Is High Risk Worth It?
Public equity is an asset class notoriously subject to the whims of the market minute by minute, whereas commercial real estate has historically proven to produce more stable, reliable, and predictable income It also offers the following three benefits that stocks can't bring to the table:
- Appraisement based on concrete, consistent line items such as rental income and the cost of operations
- Ownership of a hard, tangible asset, rather than a valuation on paper
- Capital appreciation accrued as a property's resale value increases.
So, is the liquidity advantage of public equities worth the investment risk long term? Advisors who are advocates of a moderate, steady, long-term growth strategy would likely think not.
Strong Assets, Predictable and Combatable Risks
Although none of us is in possession of a crystal ball, the case for commercial real estate investment over public equities is a powerful one, even when the risk factors unique to real estate are considered.
The three main risks that are listed below. Each of these risk factors can be mitigated with the following prescribed strategies:
- Liquidity risk. Because real estate is less liquid than stocks and equity investments, an argument could be made against investing in commercial property and commercial real estate private-equity funds due to the limited ability to take out the principle until the investment matures. That said, investors who are playing the long game can reduce this risk by keeping an ample cash reserve to self-insure against emergencies requiring large amounts of capital.
- Interest rate risk. Real estate deals tend to be leveraged, which in turn causes rates to affect real estate investments. For example, when rates go up, the cost of real estate deals go up, and returns go down. But this risk can be effectively alleviated by projecting debt cost early into negotiations and locking in rates per project, as well as by refinancing projects if rates go down to improve overall cash flow.
- Reinvestment risk. Reinvestment risk, or the risk of having difficulty finding a profitable asset to reinvest returns into, affects stock and equities as well as real estate. However, it is arguably of greater significance in the real estate investment sphere. This is because real estate property is inherently more finite than that of stocks; there are fewer buildings being built each year than there are initial public offerings in the stock market.
So, when a real estate asset matures and it is time to reinvest that capital into another property or CRE private-equity fund, it is possible that the market has shifted and fewer promising properties are for sale than existed previously. But the cyclical nature of the real estate investment market allows foresight into what times will be best to sell and reinvest gains, and markets all over the country are wildly different. New opportunities can typically be found if an investor knows where to look.
Steady Strategies Prove More Sustainable Over Time
The Dow Jones Industrial Average continues to hit record highs this year, and the temptation to strike while the iron's hot is, understandably, quite strong. But the time to buy is when the market is low (read: cheap), not at its overpriced peak.
History has proven time and again that investors must play the long game in order to be successful, and commercial real estate investments are by nature built to last. Family offices and advisors should keep this reliable asset class in mind while considering strategies for balancing clients' portfolios. Real estate is a tangible asset with a low risk for devaluation and a near guarantee of a consistent return in the form of rental income. Stock may seem sexier, but real estate is steadier, and that is the attribute that ultimately wins the race.
This is part of a 30-30 series on navigating the growing world of client portfolios.