Having the proper framework is critical to benefit from the current repricing.
Single-family offices are a heterogeneous group of investors and differ in various categories; in particular their size or the targets for generating the target returns. What they have in common is not only that a team of professional investment specialists manage the principal’s or family’s assets, but also that they typically have the luxury of a longer-term investment horizon.
We have observed, though, that the management of real estate is not as consistently handled as the management of liquid asset classes or private assets. Some family offices do not even see real estate as part of the financial wealth but consider it outside the traditional asset allocation. Others prefer Private Debt and Private Equity but omit real estate assets from their private market allocations. There are also family offices that prefer individual direct deals because the process of acquiring and selling real estate is, in part, one of the hobbies of the principals. However, this does not lead to a diversified real estate portfolio but rather an irrational selection of collector’s properties.
By looking at real estate in a piecemeal fashion, investors miss out on significant benefits of real estate in multi-asset class portfolios. In a diversified real estate portfolio, investors could earn a decent risk premium over time at relatively low volatility. Due to their low correlation to equities and bonds, diversified real estate portfolios yield far-reaching diversification gains. However, the emphasis should be placed on diversified real estate portfolios. Focusing on individual deals can sometimes result in unacceptably high idiosyncratic risks. For instance, an investor with an office asset that is excessively large relative to their total wealth, financed at a high loan-to-value ratio, could potentially lose all of their equity in such a deal. This situation could have catastrophic consequences for their financial wellbeing.
Indirect real estate
As a rule, a portfolio of at least thirty properties is necessary to achieve a diversified portfolio. With this minimum number of assets, you can limit the impact of the idiosyncratic risks described above on the whole portfolio. If you want to implement this, you need not just a minimum portfolio value of around one billion USD but also a larger team of direct real estate specialists. This is because a direct real estate portfolio must always be actively managed.
We see an indirect approach to real estate as a step towards professionalizing real estate investment management. By subscribing to non-listed real estate funds, entering JVs or co-investments in combination with listed investments, a diversified real estate allocation can be comfortably achieved. This also ensures that the portfolio is managed professionally. By selecting the best managers in the respective markets, a family office can switch between specialty themes or regions that promise the best returns at the appropriate time. If done directly, it would take much more time to build up competencies in diverse sectors such as hotels or data centres. The good thing is that when those are no longer required, one can choose to reallocate to other themes rather than to have an inflexible fixed cost base.
Current repricing as an opportunity
Real estate markets are going through a tough patch currently in many regions and sectors. The substantial increase in interest rates has not only brought about higher mortgage financing costs but also has led to a reallocation of some quota out of real estate towards bonds or cash. This makes sense in some markets. In the US, T-Bill ETFs currently yield 5.25%-5.5%, while distribution yields for some core open-ended diversified real estate funds are still below 4%.
At the same time, the extent of price correction offers convincing opportunities to allocate capital in the sector. This is especially true for those investors who still don’t have an international real estate allocation.
Legacy v new vintage funds
The current uncertainties are still elevated, and the appropriate strategy to deploy money requires a deep understanding of real estate markets and investment structures. Historically, investors have managed their real estate risk profile by allocating capital to core, value-added or opportunities strategies. While the categorization remains valid, we would currently distinguish between legacy funds and new vintage funds. The primary characterization of legacy funds, like most open-ended European, Asian or US structures, is that they rely on external valuations of their portfolios. So, investors enter such a fund typically at the current NAV.
Unfortunately, appraisals tend to lag, especially in times like these. We still believe that most of such products are still overvalued compared to where those assets would currently trade. So, NAVs should continue to trail down over the next quarters. We would only suggest investing in such funds via secondary markets at discounted values.
New vintage funds follow a different character. They are now raising money they are deploying in the current market environment. These can be core products now being launched, or new vintage value-added or opportunistic funds. Their common characteristic is that they can now benefit from the repricing. We believe they can deploy money at cap rates that are often 150-200 basis points above the implied cap rates of legacy products.
What’s also important is not to solely seek those assets that have undergone the most significant repricing, but to concentrate on asset classes with promising net operating income growth prospects. We believe that currently, the best opportunities are to be found in Europe, where we see Scandinavia as the most attractive region, alongside the UK and Spain. We believe that most US assets need some more time to reprice. But looking at the coming two years, it seems to us an exciting time to increase exposure to US and APAC markets.
Overall, the current market weakness in real estate should enable investors with existing real estate portfolios to alter their existing portfolio by adding themes that make it more future-proof. Investors who didn’t have an international indirect real estate allocation in the past now have an excellent opportunity to build up long-term real estate exposure from scratch at more reasonable valuations than some years ago.
