Executing a Diversified Real Estate Strategy in Today’s Investment Environment

The evolution of real estate investing continues to open new doors for investors – far beyond the direct ownership of real assets. There are numerous options for investors to gain exposure to this asset class with the potential of income-focused returns, however, they vary drastically in terms of objectives and structure.

Public markets offer access to a variety of real estate securities, most notably real estate investment trusts (REITs), which provide a passive investment in a collection of properties grouped by sector, geography, or risk profile.

There are other options for accredited investors in the private sector, including institutional funds and non-traded REITs, which may help limit volatility away from broader markets and seek to drive higher returns in exchange for their built-in liquidity risk.

Yet, investors in search of income-focused returns and lower volatility may be shut out from the private market by suitability requirements, limiting their exposure to only more volatile REIT equities. However, this is beginning to change.

Over the last few years, an innovative structure has become more prevalent for retail investors wanting exposure to private real estate. This new structure is called a closed-end, 40-act interval fund.

These funds price daily at net asset value (NAV) but are not listed on an exchange, so they do not trade higher or lower than NAV the way typical closed-end funds do. Interval funds also allow investors the opportunity to redeem their shares back to the fund at NAV on a periodic basis (from monthly to annually).

Because of this unique structure, interval funds can provide access to less-liquid investment strategies, which may result in higher risk-adjusted returns. Real estate interval funds continue to grow in popularity for retail investors who seek income-focused returns with lower volatility.

As with any real estate investment, no two real estate interval funds are the same. The challenge for investment managers is how to best balance the tradeoffs between liquidity, volatility, income, and total returns.

Most real estate interval funds overdistribute their dividends and overweight the lower-yielding private sector in an attempt to seek higher total returns and dampen volatility, which subjects their investors to higher liquidity risk, especially in a market sell-off. This strategy is making a one-way bet on the direction of real estate valuations without flexibility to shift directions quickly in a late-cycle market environment. It takes a long time to redeploy large positions in private equity investments, even if the investment vehicles offer some measure of discretionary liquidity.

Then there are those interval funds that seek to take measured diversification to the next level by implementing a truly uncorrelated real estate investment strategy that incorporates public and private real estate equity and credit investments, similar to the one employed by large, sophisticated institutions.

A fund manager may want to overweight private equity during an early-cycle period of declining interest rates, or when a seemingly-overpriced public market offers less upside potential. Conversely, overweighting public equities may make sense when the underlying securities are at high discounts to NAV, similar to the massive, interest-rate-induced selloff that unfolded at the beginning of the year. At the same time, allocating a higher percentage to floating-rate real estate credit may be warranted during a rising rate or recessionary environment.

Simply put, today’s markets call for an investment strategy that offers active managers flexibility to quickly adapt to changing market conditions, especially as we move later into the current real estate, credit, and economic cycles. Credit sits higher in the capital structure, which helps to insulate portfolios from moderate to significant changes in commercial real estate values. For example, an office or apartment building that modestly cuts rents, in parallel with market rent declines, will have a lower valuation, but it should still be able to service and refinance its debt. Moreover, unlike fixed-rate assets, floating-rate commercial real estate credit investments provide income that adjusts with rates, which should help dampen a portfolio’s interest rate risk. For investors utilizing real estate investments for their income potential – of which there are many – floating-rate commercial real estate credit could be an attractive component of a diversified strategy.

While investors leave these allocation decisions to fund managers, it is important to understand an investment strategy’s adaptability as we sit firmly in a new normal of rising rates and late-cycle growth. Proactive fund managers will search for Alpha opportunities that are always embedded in different parts of the capital stack throughout a cycle. Securing that potential may include value-add equity strategies that are driven by property-level value creation instead of core sector-level capital appreciation that is typically guided by rising rents in a benign interest rate environment.

Investors asking how to extract value in today’s environment must look for the structure and strategy that best fits their needs and future market conditions. Real estate interval funds prove to be an ideal option for retail investors, allocating across public and private markets in the search for risk-adjusted, income-focused returns.

To view an interval fund’s unique risk factors, click here.

Justin Milberg and Gene Nusinzon are Portfolio Managers at Resource Real Estate Diversified Income Fund. The views expressed here are the author’s own and not that of ALM’s Real Estate Media.