For the past several years, investors in large REITs have consistently benefitted from a rising real estate market that has yielded year-to-date returns through October as high as 10 percent. But with interest rates rising and cap rates expanding, values and, thus, returns have been going through an adjustment. Investors have moved quickly to request redemptions from several well-known non-traded REITs. With requests now exceeding monthly redemption limits, these funds have started limiting redemptions, rattling some investors who chose this type of commercial real estate structure precisely for its liquidity.
In today’s rising interest rate environment, investors with exposure to real estate might want to ask themselves: Is there risk in being overly conservative?
As investors, we learn early about the importance of diversifying our portfolios. But diversity across asset classes isn’t enough. Investors should ideally diversify within individual asset class categories, as well. For real estate, that may mean balancing income-producing properties that typically generate modest yet steady returns with more growth-oriented investments that can potentially produce higher returns over a longer period.
Many large REITs are composed primarily of core and core-plus properties— typically buildings that are stabilized and leased up—meaning that investors are simply collecting money off rents from existing tenants. But when property values decline, investors may not only see their returns evaporate; they may also be prevented from gaining access to their assets—if those funds limit redemptions. Today, investors are learning that there is risk in being in a perpetual buy-and-hold cycle.
To protect themselves, financial advisors and clients who have traditionally maintained what they considered a conservative strategy might now consider it more prudent to redirect a portion of their real estate holdings into more growth-oriented properties.
In addition to historically having a low correlation to public markets, value-add, opportunistic and ground-up developments typically offer the potential for higher returns. Unlike core real estate, these types of investments have a more limited lifespan, typically three to five years, as they’re not meant to be bought and held. And because these projects involve either renovating an older building or developing a brand-new one, they have the potential to deliver greater returns, initially generating modest income when buildings begin to lease, followed by larger capital distributions when the property is eventually sold.
Though no one can predict what the market will look like in three, four, or five years, if you’re doing proper due diligence, and identifying properties that offer the potential for growth, both from a geographic and thematic perspective, you’ll be in a stronger position to both weather the current market and potentially generate returns further down the line. For example, we expect trends such as migration to Sun Belt states and the strength of industrial and warehouse properties to extend into the next market cycle and perhaps beyond.
Of course, the potential for higher returns also comes with added risk, which, in this case, might involve higher than expected materials costs, failure to complete the building or being unable to find a buyer. To help mitigate risk, advisors may identify an investment partner with deep ties to sponsors and developers and extensive knowledge of the various markets.
When it comes to real estate, investors would be wise to consider the full picture of their portfolio, including investment thesis, location and asset type. As with other investments, one way to help protect against volatility in the real estate market may be to construct a well-rounded portfolio that provides exposure to different strategies, with opportunities to generate alpha both in the immediate and long term.
Sheldon Chang serves as president of CrowdStreet Advisors, LLC, a registered investment advisor and a subsidiary of CrowdStreet, Inc.