The investing landscape has changed meaningfully over the last 20 years. Gone are the days of calling your broker to buy or sell shares or looking up stock quotes in the daily newspaper. In the modern era, you can invest in almost any asset class, across any global market simply with the click of a button. ETF’s have lowered the cost of diversification, and now technology is making all types of alternative investments available to high net worth individuals searching for new and novel ways to invest their capital.
So why has commercial real estate investing barely changed at all? Buying a single commercial building still requires working with a broker, signing reams of paperwork, and waiting for an extended period to close. Real estate funds have barely changed as well. Many still charge acquisition fees, only specialize in one product type, and carry leverage in excess of 50%, despite the disastrous consequences that ensued from such structures during the 2007-2009 period. Where is all the innovation in real estate investing?
The one pocket of commercial real estate that can claim a rising level of sophistication is the publicly traded REIT market. REITs have harnessed the benefits of technology to better fit investor needs while focusing on building sustainable, and investor friendly, corporate structures. REIT ETF’s provide low-fee diversification into high quality commercial real estate. They are also liquid and provide much lower levels of risk due to lower leverage levels than many private funds. For these reasons, REITs represent a step forward in the commercial real estate investing game and open the door for the most sophisticated of modern-day real estate investing products, the REIT hedge fund.
Combining REITs with a hedge fund structure unlocks an entire new world of possibilities within commercial real estate investing. There is no other structure that allows an investor to go long multi-family apartments while shorting shopping centers. Additionally, in the private market you can never buy a high-quality portfolio of New York office assets at a 20% discount to their private market value. A REIT hedge-fund can and is able to consistently capitalize on these types of opportunities.
In a REIT hedge fund, the variety of real estate portfolios that can be constructed is endless. Additionally, as a liquid vehicle, a REIT hedge fund offers the ultimate flexibility in terms of investment size and timing. In an era in which the investing landscape changes by the day, REIT hedge funds truly represent the modern frontier in commercial real estate investing.
REITs: Under-appreciated quality, liquidity and optionality.
The publicly traded REIT market is one of the best ways to add real estate exposure to a portfolio, but it remains conspicuously absent from most investors’ asset allocations. There are a multitude of reasons for this, but we find that investors’ hesitation is often based on REIT misconceptions. There are three key characteristics of REITs, however, that we believe can clarify and assuage most investor concerns regarding the space.
Quality: REITs own the highest quality commercial real estate in the country. Period. In order to become a successful publicly traded REIT, you need to have a real estate portfolio of over $2 billion, then successfully convince some of the most sophisticated real estate investors in the world that your stock is worth owning. Only the highest quality commercial real estate portfolios and management teams pass this test and go on to succeed as publicly traded REITs. Most private real estate teams cannot compete with the average REITs level of sophistication, cost of capital, or portfolio quality.
Liquidity: Publicly traded REITs are the ONLY liquid option for investing in commercial real estate. As an investor, you can buy or sell a REIT portfolio at a moment’s notice, in almost any dollar amount. The largest REIT funds consistently move $10, $20, $50, or $100 million chunks of capital in and out of the REIT market. Contrast this with private real estate investing, in which deals can take months to underwrite, bid, and win, and even longer to close (whether buying or selling).
Optionality: With over 20 distinct property type investments available in the REIT universe, there is no more flexible option for commercial real estate investing than the publicly traded REIT market. In addition, the REIT market contains property type investment options that are widely UN-available in the private market; Data Centers, Cell Towers, and Casinos are three quick examples of real estate exposure that investors would be hard pressed to find in the private market. In the REIT market, exposure is available with the click of a button.
REITs in a Hedge Fund: Tapping the true potential of REIT investing.
High quality commercial real estate in a liquid vehicle is a compelling offering. Most sophisticated investors have realized this and allocate to REITs in one form or another. Everyone from David Swenson of the Yale endowment to the largest pension managers in the world such as CALPERS have actively or passively allocated to REITs for years. It’s worth asking the question, however, of whether we can do better than simply owning REITs in an ETF or mutual fund?
As a quick aside, let’s discuss what the term “Hedge Fund” means. A hedge fund in its essence is a legal structure in which a hedge fund manager has a high level of discretion over how their fund invests. In the case of a hedge fund focused in REITs, this means that the manager has flexibility to invest in the REIT market as he or she sees fit. This opens the possibility for not only buying and holding REITs (“going long”), but also of betting against (“shorting”) REITs.
Ok, back to the important question: can we do better than a REIT ETF? And are there advantages to owning REITs in a hedge fund structure?
To answer the first question, we can look at a few widely researched and accepted strategies for picking stocks; value, momentum, and quality investing. Each of these investing styles has been shown to add value over time within the broader stock market when employed systematically**. Said another way, over time you will do better than average if you consistently buy value, momentum, or quality stocks. In fact, when you combine the three into a composite (what quants refer to as a multi-factor model), you historically can do MUCH better on average than the overall stock market. But does a similar strategy work in the REIT market?
In a word…yes. The chart below shows the REIT benchmark since 2010, as well as the performance of a strategy that consistently re-balances into the top value, momentum, and quality REITs. Over the last 9 years, the REIT index has returned 13.3% on an annualized basis, which is excellent. However, the multi-factor value, momentum, and quality model returned 17.4% on an annualized basis, which translates to returns that are 128% higher over the entire period. A $10,000 investment in the REIT index would currently be worth $32,500, while a $10,000 investment using the model would be worth $45,314. That’s a 30% difference in the number of dollars in an investors pocket at the end of the day.
Now let’s see if adding the ability to short creates any additional value. Using our model from above, let’s assume the portfolio was invested at 130% long, 30% short. Hedge funds have the flexibility to not only short stocks, but also to borrow against these shorts, allowing our long exposure to increase to 130%. We can take REITs that have the worst scores in the model and use them as shorts in this permutation of our original strategy.
The chart above tells the tale clearly. Adding shorts to the portfolio adds another layer of value that is un-available to REIT funds that cannot short REITs. The 130/30 portfolio has an annualized return of 20.4% versus the benchmark at 13.3%. Over the entire period that’s a return of 474%, versus the benchmark at 225%, a difference of 249%. That $10,000 investment discussed above would be worth $57,404, a tidy $24,905 higher (77% more) than a $10,000 investment in a comparable REIT ETF.
Assembling the pieces: REIT Hedge Funds represent commercial real estate investing’s new frontier
While many investors embrace commercial real estate as an asset class, it’s much less common to see REITs as a stand-alone allocation within an investor portfolio. It’s even rarer still, to see REITs held within a flexible vehicle such as a hedge fund, as these products represent the cutting edge of commercial real estate investing.
As the economy and capital markets continue to evolve, those that embrace innovation will continue to take share from those that do not. Investors that are not aware of the power of REITs will fall behind those that are, and those taking advantage of the flexibility afforded by the REIT market have the potential to set the pace in the years ahead.
Using straightforward quantitative models borrowed from prominent equity investors it is possible to construct a model that takes advantage of the optionality and liquidity of the REIT market. Deploying this model in a hedge fund structure and adding short sales further enhances the model’s edge, delivering historical returns that are compelling both nominally, and on a risk-adjusted basis.
Knowing all this, the question real estate investors need to ask themselves is, “am I comfortable with the quality, diversification, and liquidity of my commercial real estate holdings?” The option always exists to improve portfolio quality, add diversification, and enhance portfolio liquidity by adding REITs. For those investors willing to push the envelope and invest in a hedge fund, the potential for outsized returns in commercial real estate in the modern era is hard to ignore.
Which version of commercial real estate investing will you include in your portfolio?
For more information on how Serenity Alternatives is embracing commercial real estate investing’s new frontier, feel free to contact Martin Kollmorgen at Mdkollmorgen@SerenityAlts.com.
**For an industry leading exploration of value and momentum see https://www.aqr.com/Insights/Datasets/Value-and-Momentum-Everywhere-Factors-Monthly
Martin Kollmorgen, CFA
CEO and Chief Investment Officer
Serenity Alternative Investments
Cell: (630) 730-5745
**All charts generated using data from Bloomberg, LP, S&P Global, and Serenity Alternative Investments
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