A 2016 McKinsey Global Institute report suggests the combination of higher interest rates, lower economic growth and weak corporate profits is here to stay – and a portfolio made up only of stocks and bonds will generate lower returns for years to come.

Commercial real estate has the potential to offer long-term returns that are both healthy and stable. Most significantly, when added to a traditional portfolio of stocks and bonds, this asset class can decrease volatility and increase returns. But it’s important to understand the different types of real estate investments you can make, and each one’s potential impact on your portfolio.

Access to Private Equity (PE) in the past has been limited to investors who are either institutional or high net worth investors i.e bringing cheques in the amount of $250,000 or more to the table. However, now with the advent of technology, ordinary retail investors can access a lot of PE funds through platforms like ours at R2Crowd.

While REITs are great investments “if” bought and sold at the right time, there are several key advantages that PE offers over REITs:

Volatility

While public real estate products can be liquid investments, they are highly correlated to the stock market. Adding publicly traded REITs alone will not necessarily improve your portfolio’s risk-adjusted returns.

Alpha vs Beta

When evaluating a potential investment, it important to look at alpha and beta. Beta measures the volatility of a fund relative to the market by gauging how much the fund’s returns move up or down given the gains or losses of its benchmark market index. Alpha is the difference between a fund’s expected returns based on its beta and its actual returns, and it is sometimes interpreted as the value that a portfolio manager adds, notes Morningstar.

Public REITs are a good example of the difference between alpha and beta.

With pubic REITs you are essentially buying beta, while a private equity real estate fund seeks to achieve alpha—and does with strategic business plans for properties and skilled asset managers. PE funds have typically outperformed the market on a risk-adjusted basis

When black swan hits, REITs can go down to abyss

Nobody wants to catch a falling knife!

“In 2007 and 2008, REITs lost 15.7 percent and 37.7 percent, respectively,” the Wall Street Journal noted recently. Also, since 2000, REITs “are second only to emerging-market stocks as the most volatile asset class. And with interest rates likely to rise, the next few years could be tough,” especially for investors buying REITs now, concluded the WSJ.

Typically, a REIT with a yield of 5 per cent and a distribution growth rate of 2 per cent would be expected to deliver a total annual return of about 7 per cent. It almost never works out that way, of course, because market forces, interest rates, occupancy levels and other factors all affect a REIT’s unit price.

Alignment

According to Towers Watson, a leading global advisory company, co-investment is the most effective way to align the interests of a manager and investors.

There are different PE fee models but they range anywhere from:

1% AUM fee/Yr
– 1-2% of Invested equity fee/Yr with a 70-30 or 80-20 promote after a pref of 7% to 9%
– Property management fee if applicable etc

Typically good and conservative managers of PE minimize these fee and pass max returns back to investors. They start getting a waterfall type promote in their favour sometimes but that is aligned with investor’s interest from a performance standpoint.

Fees

Compliance and reporting costs for a public issuer like a REIT can be huge and such platform costs add up quickly along with cost of raising capital. Such costs can be north of 10% when all costs are compared. A PE fund on the other hand will have these fees between 4% to 6% typically.

If private equity real estate isn’t part of your portfolio, it needs to be; asset allocation is a large determinant of investment success. Private real estate has low correlation to other asset classes, high expected returns and low volatility. That makes it a trifecta, since most asset classes only have one or two of these qualities.

In truth, when it comes to deciding between a publicly traded REIT and a private equity real estate fund, it isn’t an “either-or” proposition but rather an “and” proposition; you don’t necessarily have to choose between the two.