Private fund managers can always limit redemptions if too many investors attempt to pull their capital at one time.Isovector/iStockPhoto / Getty Images
Private real estate funds have become more accessible for retail investors in recent years, offering a new source of diversification and lower-volatility returns. But the practice of halting redemptions, or “gating,” has underscored that the asset class is not without risk.
“For many investors, real estate is a really important part of their portfolios. It’s a long-life asset that can deliver inflation-adjusted income,” says Darren Coleman, senior portfolio manager with Portage Cross Border Wealth Management at Raymond James Ltd. in Oakville, Ont.
“Some of the issues that are happening today are not a bug, they’re a feature of the system – they’re part of the risk [of investing in real estate].”
Private real estate funds tend to have lower volatility than public market real estate investment trusts and lower correlation to public markets, on the whole, says Loren Francis, principal at Oakville, Ont.-based Highview Financial Group.
Although these funds are meant to generate a premium over public markets, clients have to be prepared to accept constraints on their capital.
“Advisors need to do a good job ensuring clients understand why private alternatives are good for portfolios, but that they’re there for the long term – they’re not there for trading in and out of,” she says.
Ms. Francis says an ideal allocation to alternatives is between 5 and 30 per cent of a client’s portfolio, depending on their risk tolerance, liquidity needs and the size of their total assets.
Richard Schaupp, managing director at Clarion Partners LLC in New York, Franklin Templeton Investments’ dedicated investment manager for real estate, says there are now more private real estate funds with lower minimum investments for retail investors.
“We’ve seen a much broader group of high-quality managers enter the space over the past decade or so,” he says.
The latest generation of funds has been structured to accommodate retail investors’ need for liquidity, he says, by providing about 20 per cent of the fund’s total value in liquidity a year, or 5 per cent a quarter.
“If you want to get your money out of the fund, you could get 100 per cent of your investment out as long as not more than 5 per cent of the fund wants to get out,” he says.
However, gating is still a possibility if too many investors attempt to pull their capital at one time.
In August of last year, Trez Capital Mortgage Investment Corp. halted redemptions on some of its funds; then, in September, Centurion Apartment REIT and Nicola Wealth Management Ltd. limited redemptions to funds.
Both Nicola and Centurion said widespread investor fears about private assets had increased requests for redemptions.
“You can’t really control what other people are doing. Whenever you add your money with others, you’re also partnering with them,” Mr. Coleman says, and there’s no way to guarantee they have the discipline, capital and temperament to withstand economic headwinds.
Ms. Francis notes that private funds’ limited liquidity can pose a challenge if a client passes away. If their portfolio holds a significant share of private assets, they may not be able to be liquidated right away, she says.
In addition to liquidity risk, Mr. Coleman says investors need to understand the interest rate risk associated with private real estate funds. Depending on the underlying assets behind the fund, asset managers may need to borrow money to buy, build, or upgrade a property.
“The cost of borrowing can change your rate of return,” he says. If interest rates jump, “that’ll really upset your apple cart.”
Ms. Francis says the open, evergreen funds that provide some liquidity if necessary tend to be a better fit for clients, as they offer diversification and income for clients who are in retirement and living off their portfolios.
Some of her high-net-worth clients have entered closed funds, she says, which can’t be exited until they reach maturity and require periodic capital calls from investors.
She says Highview generally prefers multi-residential funds for its lower-risk clients, as the underlying assets are already built and generating rental income, which increases at or above the rate of inflation.
“Typically, with multi-residential, there’s always going to be a need, whether we go into a recession or slowdown,” she says.
Mr. Schaupp says assets such as warehouses, quality apartment buildings and retail centres, and health care-focused properties typically make the most sense for retail or mass-affluent investors.
“Those are asset classes that we’ve seen, for 40 years, consistent liquidity in those marketplaces. … You could probably get into much more idiosyncratic property types, [but] those could have less liquidity over time,” he says.
When evaluating funds, Mr. Coleman says he looks first at the fund manager’s track record and experience, and whether he will have access to them personally.
“If I don’t get access, I’m not buying. For investors, that’s a question for your advisor – do you have enough power to get to these people?” he says.
If the fund has a history of limiting redemptions or distributions, Mr. Coleman says he wants to understand the manager’s reasoning; it can be the sign of a “prudent manager” protecting investors, or a signal the manager is in trouble.
“It’s not an automatic bad thing,” he says. “It exists to protect everybody.”
Mr. Coleman says he also asks portfolio managers about all the ways they get paid.
“They might have, for example, a retirement home, and own the company that mows the lawn or does the drywall. I want to know all of that stuff.”
Ms. Francis says advisors should also ensure the funds have sound metrics when using leverage or mortgaging their underlying properties.