Investor interest has been focused on real estate with the recent surge in inflation. For real estate to be a good inflation hedge, the increase in cashflows must outweigh the rise in operating costs by at least the rate of inflation. We think opportunistic real estate could provide good diversification and inflation protection for institutional investors.
Real Estate Investment Vehicles
Investors can access private real estate investments via open-end and closed-end fund structures. Investors can also co-invest with developers on a project basis by providing equity or debt capital. Closed-end funds generally carry a lock-up period and provide for alpha opportunities through the long-term horizon and committed capital.
Closed-end fund managers will identify real estate opportunities in their niche area of expertise and then draw down capital to implement the investment strategy. After a holding period of three to eight years, the fund manager will typically seek to sell the property for a capital gain which would then be distributed to the fund’s investors.
Open-end real estate funds will acquire properties and generally hold on to the properties for long-term rental income. Any liquidity events in an open-end fund will generally be recycled into new investment opportunities.
Opportunistic Real Estate Funds
Opportunistic real estate funds seek to acquire real estate that needs substantial renovations or improvements to generate income. Often a fund manager will target a property with high vacancy rates or poor property management and try to deploy capital to improve asset values and cash flows.
An example would be a fund manager with logistics or warehouse expertise that would raise funds to acquire a vacant industrial facility which the aim of adding value through repurposing the property.
Investments in opportunistic real estate involve a high level of involvement from the fund manager to execute the project which will inevitably have subcontractors and other stakeholders that may impact the timing of completion, substantially affecting IRR.
Opportunistic funds are higher risk than core or core-plus real estate which have expected returns in the 10% to 15% range, versus 15% to more than 20% for opportunistic strategies. Many opportunistic fund managers will seek large amounts of leverage to develop the project, but it is important for investors to recognize that these projects can inherently support less debt because of the lack of cash flows during the development phase.
Emerging Manager Real Estate Funds
Like any investment, the investment manager and risk management team are key to the venture’s success. We seek to identify real estate managers that have expertise in a specific real estate niche and can utilize value-add strategies to improve asset values rather than simply trying to sell at a higher market multiple.
Management of costs and operating expense are key and financial controls must be in place to sufficiently track project cash flows. We prefer second and third-tier cities with higher cap rates than the larger metropolitan areas.
Additionally, we prefer funds with low leverage and a management team that can maintain optionality and mitigates risks throughout the project execution phase. Contact us for more information about high-quality real estate emerging managers.