While real estate is all around us – it is where we live, work and play – we believe that just a portion of the investable universe is attractive to own as an institutional investor. The challenge for investors is to identify the right properties to own. What makes real estate a more difficult asset class to invest in is that it typically requires hands-on experience across a wide variety of functions, from construction and leasing to financing and property operations. For niche property types, such as hotels and senior housing, operational expertise is generally a must. Real estate also remains a local business with fragmented ownership – requiring investors to have an on-the-ground presence, a deep knowledge of the market and an established network of real estate professionals. In addition, the cyclical nature of the asset class will likely leave impatient or inexperienced investors in a bind during downturns. The need for market knowledge, experience and the ability to adapt to the transformations occurring in real estate create both barriers and opportunities for investors.
At Brown Brothers Harriman (BBH), we do not seek to own the entire market. Since commencing investing in real estate in 2007, we have remained true to the bottom-up, value-based investment approach we apply to all asset classes. Our real estate investments are made based on our analysis of individual properties and tenants combined with a top-down macroeconomic view. We seek to provide current income to our clients while increasing an asset’s value by growing the property’s net operating income through hands-on asset and portfolio management. In addition, we look to reduce risk by investing with a margin of safety in properties at or below replacement cost1 as well as committing capital to investments only when they meet our stringent criteria. We believe that an allocation to real estate should span private and public markets and target both stabilized, yield-oriented core properties and assets that require heavier lifting but potentially offer higher returns.
The Role of Real Estate in a Portfolio
Real estate has traditionally served an important role in a diversified portfolio because of its ability to deliver attractive risk-adjusted returns, generate a moderate to high level of current cash flow and act as a partial hedge against inflation. Given the outperformance of public equities during the past few years, private and public real estate have generated returns short of those of public equities but above those of fixed income. However, over the long term, both private and public real estate have produced strong returns, outperforming public equities and fixed income. Admittedly, the historical returns generated by most real estate investments post-Great Recession and over the past 20 years will be difficult to replicate for the foreseeable future given high entry valuations today. However, owning high-quality, stable properties that can generate a relatively solid current yield between 5.0% and 5.5% (vs. the current U.S. 10-year Treasury yield of 2.3%) from property operations combined with moderate growth in net operating income (which increases the property’s value over time) can potentially produce attractive risk-adjusted returns in the mid-to-high single-digit range over a full cycle.
In addition, real estate investments may provide a moderate hedge against inflation in periods of economic growth, as landlords may adjust rents at lease renewals. Shorter-term leases, such as those tied to hotels (daily price adjustment) and apartment rentals (annual price adjustment), can reset their rates more frequently to keep pace with inflation. It is important to note that there is likely a lag between cash flow adjustments and inflation increases. While real estate has some ability to potentially protect in inflationary periods, its ability to do so depends on its underlying quality and lease characteristics as well as the entry barriers it possesses. As such, the primary role of the real estate investments in our portfolio is to generate competitive risk-adjusted returns and distribute an elevated level of cash from operations – not to assist with inflationary pressure.
Real estate investing is not without its risks, though. The market is cyclical, and rents and vacancies can rise and fall with economic expansions and contractions. Tenants of office buildings and industrial properties can downsize or vacate, and renters of homes and apartments can stop paying rent. While leverage can be a friend and improve returns for a property, if the investment is overleveraged and the owner is unable to service the debt, the lender can take back the keys. Other risks include changes in capital markets that could have an adverse effect on the property’s value.
Real Estate Risk Spectrum
Real estate investment strategies range from lower-risk/moderate-return core investments to higher-risk/higher-return value-add and opportunistic strategies.
Core Real Estate Investments: Lower-Risk/Moderate-Return
Core real estate investments represent well-maintained, substantially leased and occupied properties with an attractive current yield that makes up a high percentage (60% or greater) of an investment’s distributable cash flow. Core real estate offers a lower-volatility, income-producing investment strategy with historical returns that fall between traditional equities and investment grade bonds.
BBH entered real estate investing via the core real estate market segment, making our first investment in the asset class in 2007 through the BBH Real Estate Income strategy. After acquiring our first property in September 2007, our patient, capital preservation-focused investment philosophy and the financial crisis resulted in us sitting out on the sidelines for the subsequent 22 months prior to acquiring the next property. Over the past 10 years, our private core strategy has purchased 15 properties comprising apartments, shopping centers, office buildings and industrial properties across established U.S. markets, generating attractive risk-adjusted returns.
BBH further accesses the core real estate opportunity set through the public markets. In fall 2014, we began investing in public real estate through our partnership with a privately owned investment firm that targets a concentrated portfolio of publicly traded REITs and real estate-related operating companies. This long-biased, all-cap, benchmark-agnostic, long-term-oriented, value-based public real estate strategy invests in publicly traded REIT companies, real estate operating companies (REOCs) and real estate service companies. We remain highly confident in this team, which has been prudently investing in real estate for multiple decades.
Value-Add and Opportunistic Real Estate Investments: Higher-Risk/Higher-Return
Further along the risk spectrum, value-add strategies require a meaningful level of asset repositioning and re-leasing and usually use more leverage than core investments. Investors should be compensated for the added risk, and thus, private return expectations for these strategies typically target the low teens on an annualized basis after fees and expenses. Opportunistic private real estate often requires that the investor take on redevelopment and development risk to achieve target returns well above 15% on an annualized basis after fees and expenses. Value-add and opportunistic investments may include such strategies as partnering with an experienced developer to target high-quality retail properties whose tenant(s), failing to adapt to the transformational changes driven by e-commerce, have vacated or bankrupted. After the asset is acquired at a deep discount to replacement cost, it can be redeveloped and re-leased to service-oriented tenants – often at higher rents than the prior tenant base. Once the property has been stabilized and repositioned, the real estate investors can then sell it to core buyers, including REITs, high-net-worth individuals or institutions.
BBH is currently developing a value-add private real estate strategy to complement our existing core investment program. Our goal is to provide our clients with access to real estate opportunities that can generate strong absolute returns through the repositioning, re-leasing, renovation and/or redevelopment of well-located properties that have been overlooked or mismanaged by their prior owners. We have dedicated a significant amount of time thus far in 2017 evaluating top-tier private equity real estate investment firms with whom we could partner either through a joint venture or an investment in their private value-add real estate strategies. In line with how we assess managers across all asset classes, we are seeking to partner with talented investors that can source and acquire assets below replacement cost, are long-term oriented and focused on capital preservation, have demonstrated the ability to stay disciplined and patient, conduct rigorous bottom-up research and have a proven, repeatable investment process.
Competition for institutional-quality real estate investments from both domestic and international investors is steep, and capital is plentiful. What makes real estate compelling today is strong demand generators, including job growth and growth in household formation; attractive property level fundamentals, such as rent increases; and moderate supply levels, despite small pockets of overbuilding. By selectively investing in commercial real estate, one can benefit from an improving economy, obtain some level of inflation protection and offset the impact of higher interest rates on capitalization rates by taking advantage of increasing rents as leases roll over to higher market rents. In addition, real estate is undergoing significant changes linked to advances in technology, demographic shifts and changes in how people use real estate daily. Technology, for example, is a major disruptor for the sector and has a significant impact on how real estate investors build out office space, determine infrastructure needs for an industrial facility or identify the right tenant mix for a retail center. These disruptions are creating opportunities for investors with hands-on experience, local knowledge and repositioning expertise, which we expect our future value-add real estate program to take advantage of.
BBH is in the process of creating a well-balanced real estate portfolio, including both private and public investments with varying levels of risk/return targets from stable, yield-oriented assets to growth investments. We remain focused on continuing to build out our core private real estate program with an emphasis on current cash flow and capital preservation and will also be providing our clients with the opportunity to access higher-returning real estate investments across the private equity value-add and opportunistic spaces. In addition, we will maintain an allocation to public real estate as a third leg of a well-balanced real estate portfolio. Whether public or private investments, we will remain true to our core investment philosophy, focused on targeting assets at a discount to replacement cost with a strong emphasis on downside protection and competitive after-tax, after-fee returns for our clients.
This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries ("BBH") to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area ("EEA"), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority (FCA). BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries.
© Brown Brothers Harriman & Co. 2017. All rights reserved. 2017.
PB-2017-07-19-1566 Expires 07/31/2019
1 Replacement cost represents the estimated amount of capital required to build a property of equal utility at current pricing.