This paper on private real estate investing is the fourth in a series on alternative investments. The alternatives industry is making a concerted effort to gather more assets from individuals due to declining appetite from institutional investors. The purpose of the series is to help individual investors recognize the drawbacks of alternative investments before plunging in. If you are considering private real estate for your portfolio, you should be aware of the following issues:
Even as reported, private real estate returns have not been better than the outcomes of similar equity REIT portfolios.
The high fee burden, particularly for funds of funds, detracts from private real estate outcomes.
The volatility of private real estate and the correlation to public equities are much higher than believed.
Private real estate faces similar challenges as the other alternative asset classes, with a plunge in fundraising and deal activity.
Success in private real estate investment requires organizational capabilities and access that, for the most part, are not available to individuals or their advisors.
Why Private Real Estate?
The apparent advantages of investing in private real estate include:
A greater opportunity set: More than 90% of US commercial real estate is privately owned.
Greater flexibility: A private real estate operator has more flexibility in managing investments and cash flow than a REIT operator.
Perception of “illiquidity premium”: It is generally believed that illiquid investments inherently offer an “illiquidity premium,” and therefore, on average, the returns for illiquid investments will be better than liquid investments.
Perception of low volatility and correlation: The reported returns of private real estate appear to have low volatility and low correlation to other investment types.
However, as discussed below, the perceived advantages 1, 2, and 3 have not led to better investment outcomes, and advantage 4 is illusory.
Returns as Reported Can Be Misleading
Private real estate performance can be challenging to decipher, with reported returns generally skewed upward. Reported investment results are based on the Internal Rate of Return (IRR), a deeply flawed metric that typically exaggerates true performance. Valuations, as reported by private real estate firms, can flatter performance as well, particularly when real estate prices are under pressure.
Returns Lower Than REITs
Even as reported, private real estate fund returns have lagged the returns of REITs. NCREIF (National Council of Real Estate Investment Fiduciaries) maintains an extensive database of historical returns for private real estate and REITs. The following chart compares the performance of the NCREIF ODCE private real estate index to equity REITs. REITs have outperformed private real estate funds over all trailing periods, including the full 46+ years since the inception of these indices.
Cambridge Associates also maintains a long history of the performance of private real estate funds versus REITs. Their data reaches the same conclusion: REITs have been the better investment over all trailing time periods.
CEM Benchmarking compared private real estate versus listed real estate returns in US pension fund portfolios over the period 1998 to 2021. Over this 24-year period, REITs returned 9.4% per year versus 8.0% for private real estate.
Correlations and Volatility Higher Than Believed
Since private real estate returns are reported with smoothing and a lag, it can appear that the asset class has low volatility and attractive diversification characteristics. For instance, JP Morgan’s Q3 2024 “Guide to Alternatives” indicated that private real estate had recently shown a negative correlation to the S&P 500. Unfortunately, that correlation is misleading.
Reported private real estate returns were positive in 2022 when stocks went down and negative in 2023 when stocks went up. This gives the false impression of negative correlation. In reality, private real estate valuations were lagging: fund managers did not mark down holdings in 2022 and only began reflecting losses in 2023.
The following chart shows trailing one-year returns for REITs and private real estate. It is evident that private real estate returns eventually align with REIT returns—with a lag—and that reported volatility for private real estate is understated relative to the underlying asset volatility.
Over the past 20 years, the correlation between REIT returns and the S&P 500 has been 0.76. The volatility of the REIT index has been roughly 50% higher than that of the US stock market. These metrics are more indicative of the true risk and volatility of private real estate than the artificially smoothed returns reported by managers.
Manager Fees Impact Performance
High fees are a major reason for the disappointing performance of private real estate funds relative to REITs. A typical private real estate partnership might charge 1.5% of assets annually plus 20% of investment profits. If such a fee structure were applied to a 10% annual REIT return since 1994, the net return would drop to about 7.2% per year — closely matching the 25-year performance gap observed by Cambridge Associates.
Often, individual investors gain exposure through “fund of funds” vehicles, which layer on additional fees (commonly 1% management and 10% performance). The chart illustrates how paying both levels of fees (1.5%/20% to real estate managers plus 1%/10% to a fund of funds manager) could reduce a 10% gross return to just 6% per year. In other words, 40% of the investment return would go to fees.
Private Real Estate Has Challenges
Currently, private real estate faces similar challenges to private equity. Extremely low interest rates inflated property values in 2021, and managers have been slow to adjust valuations. Deal activity has dropped sharply. According to McKinsey & Company, 2023 saw the largest net outflows from private real estate on record, and global deal volume was the lowest in a decade—about half that of 2022.
Who Should Invest in Private Real Estate?
There is wide dispersion in outcomes from private real estate investing. Institutions with dedicated in-house specialists, extensive due diligence resources, and access to top-tier managers are best positioned to benefit. Large endowments and pension funds often conduct on-site manager visits, evaluate years of data, and perform deep operational reviews before investing. Individual investors, without similar access or expertise, are unlikely to achieve comparable outcomes.
Summary
Private real estate offers exposure to the same asset category accessible through REITs, yet on average, REITs have produced higher net returns with greater liquidity and transparency. As Yale’s David Swensen emphasized, individual investors are better served by diversified portfolios of liquid asset classes implemented at minimal cost. We agree. Given the structural disadvantages of private real estate—high fees, lagged reporting, and limited access—most investors are better off investing in REITs.
Explore the Full Alternative Investments Reality Check Series
[2] Definition of Equity REIT: A public company traded on an exchange that owns or operates income-producing real estate to provide dividend income to shareholders.
[3] Source: NCREIF, “NFI-ODCE Preliminary Snapshot Report,” September 30, 2024.
[4] Source: Cambridge Associates, “Real Estate Index and Selected Benchmark Statistics,” December 31, 2024.
[5] Source: Beath, A. & Flynn, C., “Asset Allocation and Fund Performance of Defined Benefit Pension Funds in the United States,” December 2022.
[6] Source: JP Morgan Asset Management, “Guide to Alternatives,” Q3 2024.
[7] Source: PitchBook, “Global Real Estate Report,” H1 2024.
[8] Source: McKinsey & Company, “Global Private Markets Review 2024: Private Markets in a Slower Era,” March 28, 2024.
Disclaimer
The information and opinions contained in this article are for background purposes only and do not purport to be complete. Atlas Capital Advisors does not represent or warrant the accuracy of the information and accepts no liability for any reliance placed upon it. This article does not constitute an offer or solicitation in any jurisdiction. Certain information has been obtained from third-party sources believed to be reliable but has not been independently verified.
Past performance is no guarantee of future results. Investments are subject to risk, including loss of principal. There is no assurance that any investment strategy will achieve its objectives. Investment advisory and management services are provided by Atlas Capital Advisors, Inc., registered as an investment advisor with the U.S. Securities and Exchange Commission.
Alternative Investment Reality Check Part 4
What’s Discussed
This paper on private real estate investing is the fourth in a series on alternative investments. The alternatives industry is making a concerted effort to gather more assets from individuals due to declining appetite from institutional investors. The purpose of the series is to help individual investors recognize the drawbacks of alternative investments before plunging in. If you are considering private real estate for your portfolio, you should be aware of the following issues:
Why Private Real Estate?
The apparent advantages of investing in private real estate include:
However, as discussed below, the perceived advantages 1, 2, and 3 have not led to better investment outcomes, and advantage 4 is illusory.
Returns as Reported Can Be Misleading
Private real estate performance can be challenging to decipher, with reported returns generally skewed upward. Reported investment results are based on the Internal Rate of Return (IRR), a deeply flawed metric that typically exaggerates true performance. Valuations, as reported by private real estate firms, can flatter performance as well, particularly when real estate prices are under pressure.
Returns Lower Than REITs
Even as reported, private real estate fund returns have lagged the returns of REITs. NCREIF (National Council of Real Estate Investment Fiduciaries) maintains an extensive database of historical returns for private real estate and REITs. The following chart compares the performance of the NCREIF ODCE private real estate index to equity REITs. REITs have outperformed private real estate funds over all trailing periods, including the full 46+ years since the inception of these indices.
Cambridge Associates also maintains a long history of the performance of private real estate funds versus REITs. Their data reaches the same conclusion: REITs have been the better investment over all trailing time periods.
CEM Benchmarking compared private real estate versus listed real estate returns in US pension fund portfolios over the period 1998 to 2021. Over this 24-year period, REITs returned 9.4% per year versus 8.0% for private real estate.
Correlations and Volatility Higher Than Believed
Since private real estate returns are reported with smoothing and a lag, it can appear that the asset class has low volatility and attractive diversification characteristics. For instance, JP Morgan’s Q3 2024 “Guide to Alternatives” indicated that private real estate had recently shown a negative correlation to the S&P 500. Unfortunately, that correlation is misleading.
Reported private real estate returns were positive in 2022 when stocks went down and negative in 2023 when stocks went up. This gives the false impression of negative correlation. In reality, private real estate valuations were lagging: fund managers did not mark down holdings in 2022 and only began reflecting losses in 2023.
The following chart shows trailing one-year returns for REITs and private real estate. It is evident that private real estate returns eventually align with REIT returns—with a lag—and that reported volatility for private real estate is understated relative to the underlying asset volatility.
Over the past 20 years, the correlation between REIT returns and the S&P 500 has been 0.76. The volatility of the REIT index has been roughly 50% higher than that of the US stock market. These metrics are more indicative of the true risk and volatility of private real estate than the artificially smoothed returns reported by managers.
Manager Fees Impact Performance
High fees are a major reason for the disappointing performance of private real estate funds relative to REITs. A typical private real estate partnership might charge 1.5% of assets annually plus 20% of investment profits. If such a fee structure were applied to a 10% annual REIT return since 1994, the net return would drop to about 7.2% per year — closely matching the 25-year performance gap observed by Cambridge Associates.
Often, individual investors gain exposure through “fund of funds” vehicles, which layer on additional fees (commonly 1% management and 10% performance). The chart illustrates how paying both levels of fees (1.5%/20% to real estate managers plus 1%/10% to a fund of funds manager) could reduce a 10% gross return to just 6% per year. In other words, 40% of the investment return would go to fees.
Private Real Estate Has Challenges
Currently, private real estate faces similar challenges to private equity. Extremely low interest rates inflated property values in 2021, and managers have been slow to adjust valuations. Deal activity has dropped sharply. According to McKinsey & Company, 2023 saw the largest net outflows from private real estate on record, and global deal volume was the lowest in a decade—about half that of 2022.
Who Should Invest in Private Real Estate?
There is wide dispersion in outcomes from private real estate investing. Institutions with dedicated in-house specialists, extensive due diligence resources, and access to top-tier managers are best positioned to benefit. Large endowments and pension funds often conduct on-site manager visits, evaluate years of data, and perform deep operational reviews before investing. Individual investors, without similar access or expertise, are unlikely to achieve comparable outcomes.
Summary
Private real estate offers exposure to the same asset category accessible through REITs, yet on average, REITs have produced higher net returns with greater liquidity and transparency. As Yale’s David Swensen emphasized, individual investors are better served by diversified portfolios of liquid asset classes implemented at minimal cost. We agree. Given the structural disadvantages of private real estate—high fees, lagged reporting, and limited access—most investors are better off investing in REITs.
Explore the Full Alternative Investments Reality Check Series
This series explores the realities of alternative investing as private equity, venture capital, and hedge funds increasingly target individual investors. Previous articles include:
Private Equity Investing,
Venture Capital Investing: Good Ideas, Disappointing Returns,
and
7 Reasons Why Individual Investors Should Avoid Hedge Funds.
References
[1] Atlas Capital Advisors, Alternative Investments Commentary – https://ocio.atlasca.com
[2] Definition of Equity REIT: A public company traded on an exchange that owns or operates income-producing real estate to provide dividend income to shareholders.
[3] Source: NCREIF, “NFI-ODCE Preliminary Snapshot Report,” September 30, 2024.
[4] Source: Cambridge Associates, “Real Estate Index and Selected Benchmark Statistics,” December 31, 2024.
[5] Source: Beath, A. & Flynn, C., “Asset Allocation and Fund Performance of Defined Benefit Pension Funds in the United States,” December 2022.
[6] Source: JP Morgan Asset Management, “Guide to Alternatives,” Q3 2024.
[7] Source: PitchBook, “Global Real Estate Report,” H1 2024.
[8] Source: McKinsey & Company, “Global Private Markets Review 2024: Private Markets in a Slower Era,” March 28, 2024.
Disclaimer
The information and opinions contained in this article are for background purposes only and do not purport to be complete. Atlas Capital Advisors does not represent or warrant the accuracy of the information and accepts no liability for any reliance placed upon it. This article does not constitute an offer or solicitation in any jurisdiction. Certain information has been obtained from third-party sources believed to be reliable but has not been independently verified.
Past performance is no guarantee of future results. Investments are subject to risk, including loss of principal. There is no assurance that any investment strategy will achieve its objectives. Investment advisory and management services are provided by Atlas Capital Advisors, Inc., registered as an investment advisor with the U.S. Securities and Exchange Commission.
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