It is not a well-kept secret: For decades, the top educational endowment funds, such as Harvard and Yale, have achieved higher investment returns with moderate volatility. Their secret is their allocation in alternative investments, including private real estate.
According to the modern portfolio theory, investors can improve the risk-adjusted returns of their portfolios by diversifying across multiple asset classes with varied correlations. Large institutions and family offices have heavily subscribed to this theory and have unlocked higher returns over a long-term investment horizon.
While the aforementioned institutions have access to billions of dollars and top private equity managers, retail investors can learn something from their asset allocation and act more nimbly to avoid the pitfalls that come with placing massive amounts of capital. Below are three ways retail investors can increase their returns by applying multi-asset principles and investing in private real estate.
1. Make The Right Selections
Private markets are heating up once again, at twice the rate of public markets, Bank of America Merrill Lynch predicts (paywall). This surge is making investment advisors reconsider their asset allocation. Cambridge Associates recommends allocating as much as 40% of a portfolio to private investments, including real estate. The firm further elaborates that there is no need to invest in “famous” funds, but that investors should look at new and developing funds that are truly top performers.
When it comes to retail investors, having an allocation in private real estate can not only provide potential for higher returns, but also a diversification strategy with low correlation to public equities. While such private investments were hard to access for retail investors, the evolution of the Jumpstart Our Business Startups (JOBS) Act created an exemption under the federal securities laws that allowed private investments the option to offer and sell to the general public.
However, even with private investments more readily available, investors should be choosy in their private real estate manager selection. The average difference between the best and the median private asset class managers was 16 percentage points. Investors should thoroughly vet their managers’ past track records and review their performance over good as well as bad economic times.
2. Do Not Follow Institutional Capital: Location
While this might sound counterintuitive to the above advice of following institutional investment strategy, retail investors can be choosier as to where to invest their funds. The majority of large private equity real estate companies perceive larger gateway markets as superior in safety and liquidity. In addition, due to the amount of capital they have to place, large institutional investors typically target central business districts (CBDs) of the major gateway cities, where they can allocate a large amount of cash on a single asset.
This targeted strategy drives prices up, and returns down, due to the sheer amount of competition in major cities. In addition to the large private equity investors, foreign buyers, whose return thresholds are much lower, also prefer these cities. This shouldn’t need to be the reality for retail investors, who, through smaller funds, can allocate to cities that are maturing in terms of job growth, technological advancements and livability.
3. Do Not Follow Institutional Capital: Size
As previously mentioned, while institutional asset allocation theory should be a guide, retail investors have a choice in which assets they want to invest in.
Prequin noted that “the total amount of dry powder in closed-end private property funds reached a record $333 billion” in March 2019. The market is seeing a record amount of cash on the sidelines, looking for investment real estate, while fund managers are having a hard time spending all of the money raised. Big funds need big assets in order to spend their cash, which in turn increases the competition for assets and lowers the returns. In addition, big funds create a big J-curve impact from slower deployment of capital, which in turn has a greater impact on investor returns.
In this part of the market, when the asset prices are high, smaller funds that target smaller assets have a competitive edge. According to research by Washington University’s Olin Business School (on which our firm collaborated), smaller (micro) assets with prices under $10 million yielded an 8.76% higher internal rate of return (IRR) than larger assets. Therefore, it would be prudent for retail investors to look into smaller funds that can use their capital quickly with smaller assets typically ignored by larger institutional funds. The best way for investors to identify smaller funds is to start reading and following the discoveries surrounding funds investing in “small balance real estate” or “micro real estate” strategies.
In conclusion, while most retail investors do not have access to the resources of a family office or an endowment, by mimicking their multi-asset principles and altering for their own size, they can achieve considerable returns and diversification.