How to Mitigate Risk When Investing in Private Real Estate

Commercial real estate (CRE) continues to draw interest among investors looking for a different source of relatively stable income and attractive risk-adjusted returns. Heightened market volatility and a persistent low-yield environment have prompted many to consider diversifying their investment portfolios with alternative asset classes. You may have experienced this trend with your clients.

Because many investment advisors have limited familiarity with private real estate, they may perceive it as a high-risk asset class. There are risk factors to consider when evaluating a private real estate offering, like those relating to credit, liquidity, interest rates, asset type, market, lease duration, and location.

But to gain a balanced perspective on the benefits and risks of an offering, it's also essential to explore the risk mitigation strategies an asset manager employs. For example, managers can often help reduce investment risk by incorporating several sources of diversification, including investment manager, liquidity, geography, property type, vintage year, and risk/return, all of which we briefly discuss here.

Investment Manager

As you know, the performance of any investment is foremost dependent on the skills and experience of the investment manager and its ability to execute successfully. Therefore, a manager's strength in acquisitions, asset and portfolio management, financing, and research should be closely evaluated in relation to the proposed investment strategy. Any deficiencies may expose investors to execution risk.

Private real estate investments that use multiple managers can add diversification and help mitigate execution risk.

Liquidity

Real estate is an illiquid asset, but publicly-traded securities like property and mortgage REITs allow investors to buy and sell positions with relative ease. Private CRE has historically been considered the most illiquid real estate investment because most offerings require extended hold times. However, specific offerings have been introduced that offer investors liquidity periodically. So, when evaluating an offering for a client, it's important to explore if the strategy helps minimize liquidity risk.

Geographic  

Geographic diversification helps reduce concentration risk to a particular market or region. In the U.S., geographies are defined by region or metropolitan statistical areas (MSAs) and categorized as primary, secondary, and tertiary markets.

Private CRE investments that hold properties across in Gateway Cities (e.g., New York, Boston, and Los Angeles), secondary markets (e.g., Dallas, Atlanta, and Seattle), and strategic tertiary markets provide the greatest opportunity to reduce concentration risk.

Property Sector

Property sectors represent a critical diversifier within a real estate portfolio. The four traditional property types are industrial, multifamily, office, and retail. More recently, there has been a focus on non-traditional or niche property types that can offer a balanced portfolio that is more stable across economic cycles and secular thematics.

Investments that hold all traditional property types and niche properties provide the best opportunity to help alleviate concentration risk.

Vintage Year

Vintage year refers to the year when the initial capital call for a fund occurs and can occur at various points of the economic cycle. The timing of the vintage year will have a substantial effect on the fund's long-term performance. Therefore, a real estate portfolio that invests across different vintage years helps mitigate overall risk and portfolio cyclicality.

Equally important to understanding the investment risks associated with a private real estate offering is the need to evaluate the underlying investment strategies designed to mitigate those risks. Investments that diversify by the factors discussed here may be those worth the greatest consideration for your clients interested in exploring this asset class.

Next Steps

If you want to learn more about why private real estate may be an appropriate allocation for your clients, download our free guide, "Why Private Real Estate?".