Real Estate

The most common real asset is real estate;¹ indeed, real estate is the largest single asset class in the world. Properly structured real estate portfolios will exhibit low correlations to equity and fixed-income assets, will provide a strong ongoing yield, will appreciate slowly but consistently, and will perform well during the periods of unanticipated inflation referred to earlier. It's a pretty compelling portrait, marred only by the fact that, over long periods of time, real estate will tend to underperform stocks, and therefore there are modest, but real, opportunity costs associated with allocating too much money to real estate.

Real estate can be further broken down into two core groups, residential and commercial. The latter includes many different sectors, including retail, industrial, multifamily, office, hospitality (hotels and resorts), and raw land. Except for raw land, real estate must be “created,” and therefore real estate assets will fall along a continuum, depending on where they fall in the stages of value creation:

• Entitlement—The property is in the process of being planned and approved, but no construction has yet occurred.
• Development—The property has been approved and is being prepared for construction.
• Construction—The structures are being prepared for occupancy.
• Lease-up—The buildings are largely completed but not fully occupied.
• Stabilized—For commercial property, this means the property is fully leased and operational. For residential housing, it means the property is sold out, and responsibility for things like maintenance of the common areas and operating the homeowners' association is transferred from the developer to the homeowners.

Leverage

It's important to understand that the use of debt (or leverage) is a core aspect of real estate investing. Leverage can magnify returns, but it can also magnify losses. Many real estate developers are hooked on leverage, and as a result they prosper mightily during good times and frequently go bankrupt in bad times.

In the late 1980s and early 1990s, the United States headed into a downturn and the capital markets shut down to real estate developers. In response, Wall Street invented the concept of a mortgage-backed security, or MBS. The premise of an MBS was that a bank would lend money to a borrower to buy a building, and the bank would then sell the loan to investors. In addition, the bank prioritized the loan so that investors could buy higher or lower in the capital stack depending on their risk appetite.

This created a new source of capital for real estate buyers, because banks no longer had to hold the mortgage on a property, compromising their capital ratios. Instead, they could sell the loan in the open market. Unfortunately, MBSs created a moral hazard, because the banks that made the loan no longer bore the risk on the mortgage.

Why Invest in Real Estate?

Real estate generally provides a slow and steady return to investors, and over long periods of time it will typically underperform other risk assets. I say “generally” because, just like other asset classes, real estate is susceptible to occasional bubble phenomena (1985–1993, 2003–2008, etc.). This usually occurs when other asset classes are out of favor and access to capital is cheap and easy.

So why invest in real estate? The main advantages of including a real estate allocation in your portfolio are that real estate tends to move in a different direction from the rest of the market, thus offering good diversification, and that real estate acts as a natural hedge against unanticipated inflation.

How to Invest in Real Estate

Assuming that an allocation is going to be made to real estate, families will have many possible strategies available to them. Among the more prominent are:

• Direct ownership. Probably the most common way to gain real estate exposure is simply to buy properties directly. More American families have created their wealth through direct real estate investing than in any other way. On the other hand, this is also the most difficult and most dangerous strategy.
• Joint venture. In a joint venture, an investor will partner with someone who has experience in direct real estate ownership. The investor relinquishes day-to-day control of the asset to the operating partner but retains authority over major decisions (refinancing, disposition, etc.). The risk is somewhat lower than direct ownership but the success of the investment still relies heavily on the outcome of a single investment, which in turn relies on the capabilities of the operating partner.
• Private partnership or fund. Like private equity deals, multiple investors invest in a pool that is managed by a general partner who has extensive experience in direct ownership. Investments tend to be passive, meaning even major decisions are delegated to the general partner. Investors usually share profits disproportionately with the general partner: Investors may put up nearly all of the capital but receive only 50 percent to 80 percent of the profits. However, the investors will normally get their money back first, and in many cases an additional amount (usually called a “preference”). Real estate funds are the recommended approach for investors who are not experienced in real estate development but who want to have an allocation to the sector.
• Fund of funds. A fund of funds is simply a fund that invests in underlying real estate funds or partnerships. A fund of funds enables investors with limited capital to build a diversified portfolio of private real estate properties. As with private equity funds of funds, real estate funds of funds will charge a management fee and may even charge an incentive fee, and that's on top of the fees being paid to the underlying managers. But the fees can be worth it for investors who cannot build a high quality allocation in any other way.

Over time, a well-structured and well-diversified real estate portfolio should generate attractive risk-adjusted returns for families, often in a tax-advantaged and inflation-protected manner. As a result, allocations in the 5 percent to 15 percent range are common in family portfolios.