An Introduction to Private Real Estate

What Is Private Real Estate?

Real estate is generally defined as tangible property consisting of land, buildings and related structures. Assets under management (AUM) grew to roughly $1.3 trillion at the end of 2021 and could rise to $1.8 trillion by the end of 2026 (Exhibit 1).

Source: Preqin Forecasts, as of Q3 2021, 2021 figure is annualized based on data to March, 2022-2026 are Preqin's forecasted figures.

Private real estate investments can be made through a direct transaction for a single property, direct acquisition of a portfolio of assets or through a diversified commingled fund. Generally, private real estate investments are less liquid than public real estate options, such as real estate investment trusts (REITs), which can be traded on equity exchanges. As a result, private real estate is typically a higher-risk investment. Importantly, as investors look to diversify portfolios and find new sources of returns, private real estate may complement exposure to traditional and other alternative asset classes (Exhibit 2).¹

Source: Preqin Investor Survey, November 2021.

A fund structure utilized for many commingled assets is a limited partnership, where the investment manager (typically the general partner or GP) oversees the investment of the fund assets and manages the day-to-day operations of the fund; the limited partners (LPs) supply capital but otherwise have a passive role.

Real estate funds can be structured as:

• Open-ended funds, which can typically be entered and exited at any time by an investor but are sometimes subject to contribution and redemption queues. Open-ended funds are often used for core or core plus strategies.

• Closed-ended funds, which tend to have a pre-defined fundraising period and lock-up period for investor capital. Closed-ended funds are typically used for value-add and opportunistic strategies.

What Are Some Types of Private Real Estate Strategies, Sectors and Markets?

Four common types of private real estate strategies span a range of risk and return profiles (Exhibit 3). Each of these may invest across particular sectors and types of markets. 

• Core strategies tend to invest in high-quality assets with high levels of occupancy, often in prime locations. Typically, these assets do not require meaningful development or improvements and much of the return is derived from current income or rent. Core assets tend to own less levered properties and are held for longer periods of time. These characteristics can give core assets a generally lower risk/return profile.

• Core-plus strategies are similar to core strategies in that they also tend to invest in high-quality assets in strong markets. However, the properties may require minor upgrades to increase cash flows and managers may add more leverage to the assets. Returns tend to be generated equally from current income and capital appreciation, which can increase the risk over core funds.

• Value-added investments typically require repositioning or re-development but generally have existing tenants and current rental income. Although there is a current income component, the majority of returns tend to come from capital appreciation. These assets tend to have a moderate level of leverage and are typically held for shorter periods of time. Value-add real estate generally has higher risk and reward characteristics than core and core plus strategies.

• Opportunistic managers often invest in special situations or distressed properties, such as halted construction, bankruptcy, ground-up development or heavy redevelopment, generally with the goal of stabilizing the asset and then selling it to a core real estate buyer. As such, the asset is typically held for a relatively short period of time compared to other real estate assets, and the majority of the return is expected to come from capital appreciation. These investments also tend to utilize more leverage to cover higher costs and to increase returns. Opportunistic real estate strategies can have higher risk/reward profiles due to the risks associated with turning around a property, the need to sell it at a profit and limited, if any, current income.

There are also four common classifications of property, as well as a number of niche sectors, which sometimes overlap with infrastructure investments.

• Industrial properties are used for warehouses, e-commerce distribution centers, logistics, production and manufacturing.

• Retail buildings are where consumers buy goods or services.

• Multi-family residential assets house multiple families, such as apartments or condominium buildings, but may also include hotels and other more niche categories.

• Office buildings are used to conduct commercial and professional work. These assets typically have long leases from tenants.

• Additional niche categories include storage, medical offices, senior housing, student housing and data centers.

The potential attractiveness and resilience of local markets, which can affect the value of the real estate asset, is typically ranked as primary, secondary or tertiary.

Considerations When Investing in Private Real Estate

• Manager Selection and Access: Value creation in private real estate can be dependent on access to attractive deals followed by the efficient management and improvement of properties. This makes manager due diligence an important part of the private real estate investment process. Investors should look for managers with experience and resources, good industry relationships, operational stability, strong risk management practices and a proven track record, in terms of performance and assets under management.

• Diversification: Investors can diversify their real estate allocation in many ways including by manager, geography, vintage year, type of strategy, property sector and type of market.

• J-Curve: Private real estate investments tend to follow a pattern called the J-curve, where they will produce negative cash flows in the early years, due to capital calls and management fees paid before there is a chance for the investment to generate returns. It may take several years until underlying investments are marked up to their current value or gains realized through exit transactions.

• Liquidity: The liquidity of a real estate investment can vary at both the property level and the fund level. Leverage used by a manager can also impact the liquidity of a property. While both of these factors can increase the risk of the investment, assets with current income can help lower risk and improve liquidity as cash is returned to investors while the asset is held.

Real estate is a well-established asset class. As investors increasingly look to diversify their portfolios and gain access to a wider range of investments, real estate may continue to play a role in portfolios in the coming years.