| Best practice real estate investing Indirect, illiquid. private, closed-end and controlled real estate investments are best practice in real estate investing, provided the investor
| - | has trustworthy and skilled investment managers at head,
| | - | can afford to place larger shares of his wealth in single investments and still achieve a decent level of diversification,
| | - | does not depend on the availability of these funds in his short-to mid-term liquidity plan and
| | - | has access to this type of investments. | |
Indirect vs. direct investments
The fact that a third party manages an investment – and not the investor himself – defines an indirect investment (not the legal structure or the fact that a fund is publicly listed). A real estate investor who negotiates the purchase, supervises the property manager and supervises or carries out the asset‘s disposition himself is investing directly (even if he is being supported by real estate and financial advisors and trustees). Although the investment managers (sub-portfolio and asset managers) of an indirect investment charge fees which lower investment returns, the increase in investment quality is well worth the expense (provided the managers are trustworthy and skilled).
The benefits of 3rd-party investment management are:
| - | Professional asset management:
In an inefficient market like real estate the quality of management is critical. Asset managers are full-time real estate professionals who are likely to generate superior investment returns. Some private investors with extensive real estate investment experience possess a comparable skill level. Most do not.
| | - | Local market expertise:
Real estate markets are fragmented. Every market is different. This is why an asset manager capable of properly evaluating the quality of a property‘s micro location in his home market is likely to fail at this task in a place he has never done business before.
| | - | Outsourced workload:
Good real estate investing takes time. This is true not only for the acquisition and disposition phases. During the holding period the asset manager needs to closely supervise property management, track expenses, follow market developments and manage tenant relations. This is particularly important for value-added projects involving renovations and re-development. Most investors are neither prepared nor willing to spend the appropriate amount of time to manage their assets themselves
| Possible exceptions to the rule (indirect equals best practice) are acquisitions of properties in the investor‘s neighborhood. This due to the profound local market knowledge the investor might have and because with an investment property „around the corner“ the close proximity allows him to supervise construction work, manage tenant relations etc. himself.
Illiquid vs. liquid investments
The public listing of real estate titles (REITs, other real estate companies, funds) guarantees a certain degree of investment liquidity to investors. Smaller investors often depend on this liquidity. The downside is that the public listing causes the correlation of these titles with the stock market to increase, which partly eliminates the positive effect real estate generally has on portfolio diversification and increases investment volatility (investment risk). This is why publicly listed real estate assets are only partly allocated to the real estate asset class. Not only do investors suffer from a higher level of risk, they also have to carry the cost for providing liquidity to – by nature – illiquid real estate assets (regulatory imposts, expensive cash reserves, depository bank fee, public relations and marketing, market maker fees etc.).
A redemption price of a fund does not eliminate downward volatility, as it is calculated based on the inventory value of the properties which is subject to revaluations. The price investors actually get for their shares is determined by deducting the redemption commission payable to the fund from the current inventory price. Furthermore, the redemption of shares by real estate funds is not guaranteed. If investors withdraw their funds quicker than assets can be sold off, the fund is simply closed (e.g. Deutsche Bank‘s Grundinvest fund in 2005). If the assets under management of a fund decrease, the investors who decide not to withdraw their funds suffer from a lower fund performance due to the fact that assets need to be sold quickly and the time to sell is determined by the need to pay back withdrawing investors, regardless of real estate cycles and state of the properties.
Private vs. public investments
If a portfolio or asset manager wishes to invest in real estate, the easiest option is to have a look what the public investment market has to offer. The various alternatives are known and marketing material is widely available. But this luxury comes at a price. Private investments should be preferred due to the following.
| - | Lower investment costs/price:
To offer an investment product on the public investment market (by listing it on a public exchange or by publicly promoting it as a private equity investment) imposes substantial costs on the initiator. Marketing and distribution alone often account for 10% or more of invested capital. The organizational requirements for such a public offering are high, which is why most providers are mid-sized to large banks. On top of the costs mentioned above, these players usually have an over-average profit margin.
| | - | Better performance due to performance-based management fees:
A performance-based compensation of investment management is more common with private investment providers. In many cases where such a fee has been defined for a public vehicle, its average share of the managements overall income is negligible. Its reimbursement largely depends on asset management fees and/or acquisition fees. Accordingly, the prime management objective is to increase the volume (not the quality) of the asset base. This is why public funds usually ignore small to mid-sized purchase opportunities, even though they might be good deals. This is also why public open-end funds don‘t hesitate to raise more capital than can be invested within a reasonable amount of time (some Swiss public funds have experienced mid-term liquidity ratios of over 40%). The resulting pressure invest the capital by purchasing new assets increases the probability of closing mediocre or even non-performing deals.
| | - | Better performance due to strategic flexibility:
With public marketing comes a very rigid investment strategy (limitation to certain real estate sectors, locations etc.). The effort to reposition an investment brand in investor markets is often considered to be too high. This limitation to the strategic flexibility eventually lowers the funds performance.
| | - | Lower risk due to investment transparency:
Year-end reports and marketing material of publicly offered investment vehicles look very professional and contain a lot of information. But usually not the information needed for a proper evaluation (management supervision) or investment due diligence. Or the information is well hidden within the documents. The financial status and the general course of business are more transparent with private real estate investments.
| Closed-end vs. open-end investments
Investment managers of closed-end funds raise a set amount of capital to invest in real estate. The target investment(s) is (are) often pre-defined. With open-end investment vehicles the growth of a real estate portfolio is financed with step-by-step capital increases (enlarging the equity base of the legal entity).
Closed-end investments should be preferred due to the following reasons:
| - | Better performance due to more efficient use of resources:
The more assets under management, the better for the asset manager, as his earnings are closely tied to investment volume. This is why in case of asset dispositions the management of an open-end fund will prefer to re-invest the capital instead of paying back equity or distribute returns to investors. Until an appropriate investment comes along, the liquidity is usually locked in short- to mid-term fixed-income accounts. For the management of these funds the investors usually still pay the full asset management fee.
| | - | Shorter term (unlisted investments):
A reasonable timeframe for a single, actively managed investment is about 2 to 8 years. If a closed-end fund is meant to hold multiple investments, the longest one defines the funds life span. Open-end, unlisted investments are usually set up for an investment period of at least 10 years, if not infinite. As there is no binding agreement concerning the term, investors can never rely on the investment vehicle to be liquidated according to their financial plan.
| | - | Less risk due to reduced complexity:
The only sure way to exit an open-end investment is to sell the shares. If the title is not listed, it becomes extremely difficult to calculate a fair share price. There is no market data for the titles and appraisals are highly unreliable. The same problem occurs every time more shares are being issued in order to increase the equity base. To sufficiently handle this complexity, substantial organizational and technical measures must be taken. These costs easily offset the costs of setting up a dedicated legal structure per investment. The complexity of properly calculating the value of non-listed, open-end funds brings the risk of buying high or selling low. It also generally hampers management supervision to be performed by the owners.
| Controlled vs. uncontrolled investments
Management responsibility and voting power should be centralized in order to fully control an investment.
| - | Less investment risk due to centralized / aligned voting power:
If a portfolio manager only represents one investor in a specific investment, this investor should hold the majority of the votes in order to fully secure that his interests are being pursued. Otherwise, the portfolio manager of the other investors could decide on a premature exit due to liquidity problems of his clients. If a portfolio manager represents multiple investors in the same investment, they should collectively hold the majority of the votes. But none of these investors should dominate the investment by himself. A general exception to the rule of centralized voting power is if the nature of the investment defines the exit (e.g. development in cooperation with a developer whose compensation is largely performance-based).
| | - | Less investment risk due to centralized management responsibility:
A single portfolio manager and a single asset manager should be in charge of the investment and collectively perform the overall investment management function. Clear roles and responsibilities facilitate investment success.
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