For institutional investors such as public pensions or insurance companies, real estate can play an important part of an investment portfolio. As an asset class, real estate has several qualities that make it an attractive alternative to more traditional investments like stocks or bonds. Real estate can generate attractive current income yields, and as a tangible asset class it offers a partial offset against long term inflation. ((Robert B. Bellinger et al, Public and Private Real Estate: Exploring Trade-offs, 1, ASB Real Estate Investments (Jan. 2012), http://www.asbrealestate.com/data/images/asb%20research%20-%20public%20and%20private%20real%20estate.pdf; see also E. Todd Bridell and Alan Supple, Public and Private Real Estate: Room for Both in a Diversified Portfolio, 2, BNY Mellon Asset Management (Sept. 2011), http://us.bnymellonam.com/core/library/documents/knowledge/AssetAllocation/sUrdang_pubpri_re.pdf.)) Real estate also provides diversification benefits because of its generally low correlation with other asset classes. ((Bridell and Supple, supra at 2.))
Two options available to institutional investors interested in real estate are publically-traded REITS and private equity real estate funds. Traditionally, institutional investors have invested a large majority of their real estate allocations in private equity funds. ((Commercial Real Estate Investment: REITs and Private Equity Real Estate Funds, 3, Morningstar (2011), http://www.reit.com/portals/0/PDF/Morningstar-Report-REITs-and-Private-Equity-Real-Estate-Funds-2011.pdf (2010 survey showed that major tax-exempt investors planned to invest 96.5 percent of real estate allocations to private debt or equity funds and 3.5 percent to publically traded REITS); see also A.D. Pruitt, A Battle for Investor Cash, Wall St. J. (May 5, 2010 12:01 AM), http://online.wsj.com/news/articles/SB10001424052748704866204575224541021571152, (In 2010, institutional investors invested 62 percent of real estate allocations in private equity funds).)) This disparity has been attributed to the perception that private equity real estate funds have lower levels of volatility that publically traded REITs. ((Julie Segal, Despite REITs’ Virtues, Institutions Still Favor Private Real Estate Funds, Institutional Investor (April 30, 2013), http://www.institutionalinvestor.com/Article/3198472/Despite-REITs-Virtues-Institutions-Still-Favor-Private-Real-Estate-Funds.html.))
REITs must be registered with the Securities and Exchange Commission and are publically traded ((Real Estate Investment Trusts (REITs), U.S. Securities and Exchange Commission (hereinafter “SEC”) (Jan. 17, 2012), http://www.sec.gov/answers/reits.htm.)) and are usually organized around a focus on a specific asset class or geographic area ((REITs Versus Real Estate Private Equity Funds: Who Wins?, Commercial Property Executive (hereinafter “CP Executive”) (December 28, 2011), http://www.cpexecutive.com/newsletters/capitalmarkets-newsletter/reitscolumn/reits-versus-real-estate-private-equity-funds-who-wins/.)) This provides share value transparency and a higher degree of liquidity relative to private equity real estate. ((SEC, supra; CP Executive, supra.)) Higher transparency also means that REITs assets will be re-priced more quickly and efficiently. ((Morningstar, supra at 6.)) REITs also tend to use less leverage than private equity fund, allowing managers to focus on the underlying assets rather than maximizing the effect of leverage. ((CP Executive, supra.)) Furthermore, the perception that private real estate has lower volatility may be illusory. Because private real estate values are appraised periodically, rather than daily like publically traded REITs, their values appear more stable even though they may not be. ((Bridell and Supple, supra at 6.))
Private equity real estate funds are generally organized around the risk-level of the underlying assets and the amount of leverage employed.  ((see Morningstar, supra note 1 at 4.)) Because they are not limited by area or specific asset class, private equity real estate allows for nimble, opportunistic buying of whatever assets the managers believe to be at the bottom of the market cycle ((CP Executive, supra.)), managing the fund’s risk profile through leverage decisions. ((Bridell and Supple, supra at Ex. 1.)) Private equity real estate also allows institutional investors’ investment to reflect the true net asset value instead of market fluctuations. ((Pruitt, supra note 2.)) While private equity real estate funds have been viewed as more illiquid than REITs during market turmoil ((Morningstar, supra at 8.)), this is not necessarily a disadvantage. Because REIT prices reflect market fear and investor panic, greater liquidity can allow investors to lock in their losses at the most distressed time in the market ((Bellinger, supra at 1.)) In the latest downturn, REIT stocks declined by around 68 percent peak to trough versus a 38 percent decline in direct real estate ((Id.)) As such, liquidity is most valuable before a market panic begins, a time when both publically traded and directly held real estate will have relative liquidity. ((Id. at 2.))
Advocates for REITs will point out that over a given period of time, publically traded funds generally provide a higher absolute return. ((see Morningstar, supra note 1 at 5(noting that over the course of a full market cycle of 17.75 years REITs produced an annualized net total return of 13.4 percent annualized compared to 12.0 percent for opportunistic funds, 8.5 percent for value-added funds, and 7.6 percent for core funds).)) However, those figures do not consider the risk levels of the portfolios. Although REITs have outperformed private real estate since 1994, those returns were associated with much higher short-term volatility. ((Bridell and Supple, supra at 5.)) Once the returns were adjusted for risk, private equity provides higher returns per unit of risk. ((Id.)) Other studies have found that private real estate produces between 75 and 200 percent greater returns per unit of risk when compared to public real estate. ((Bellinger, supra at 2.))
For investors who are able to absorb increased risk and for whom liquidity is paramount and unavailable from other sources, REITs can be a prudent and profitable part of a portfolio. However, because of the diversification benefits, closer ties to underlying assets, and higher risk-adjusted returns, private equity real estate offers a more attractive option for investors primarily interested in long term stability and lower risk levels.
 Three broad investment strategies emerge: core, with lower risk domestic investments with relatively little leverage; value-added, with higher risk domestic and/or international investments and a moderate amount of leverage; and opportunistic, which invest in even higher risk properties using even higher amounts of leverage. ((Morningstar, supra at 4)).
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