With real estate a firm part of the capital allocation matrix for both institutional and
retail investors, real estate funds have been seeing increasing growth recently.
Due to the capital-intensive nature of real estate investing, its requirement for active
management, as well as the rise in global real estate opportunities, institutions seeking
efficient asset management are gradually moving to real estate funds of funds.
The same is true for retail investors, who now benefit from access to a much larger
selection of real estate mutual funds than before, allowing for efficient capital
allocation and diversification. Like any other investment sector, real estate has its
pros and cons. It should, however, be considered for most investment portfolios,
with real estate investment trusts (REITs) and real estate mutual funds seen as possibly
the best methods of filling that allocation.
Real Estate for Institutional Investors
Real estate investment has long been dominated by large players: pension funds,
insurance companies, and other large financial institutions. Thanks to the globalization
of real estate investing and the emergence of new offshore opportunities,
both allowing for a greater degree of diversification as well as return potential,
a permanent place for real estate in institutional portfolio allocations is developing
as a trend.
The permanent allocation of real estate capital comes with certain hurdles.
First and foremost, it is capital intensive. Unlike stocks that can be purchased in
small increments, commercial real estate investments require relatively large sums,
and direct investment often results in lumpy portfolios and inordinate risks in either
location or by property type. Real estate also requires active management, which is
labor intensive. Managing a real estate allocation requires significant resources as
compared to traditional investments. As a result of these issues, aiming to increase
management efficiency and capital distribution, institutions tend to gravitate toward
real estate funds and funds of funds. These same advantages can be achieved by
retail investors through REITs, REIT exchange-traded funds (ETFs), and real estate
Here are several ways for retail investors to access the return potential of real estate
and obtain exposure to the asset class.
This strategy relates to investors directly selecting specific properties. The great advantage
of this strategy is control. Direct ownership of property allows for the development
and execution of strategy, as well as direct influence over return. However, direct
investment makes it very difficult to create a well-diversified real estate portfolio.
For most retail investors, the real estate allocation is not large enough to allow the
purchase of enough properties for true diversification; it also increases exposure to
the local property market, as well as property-type risks.
Real Estate Investment Trusts (REITs)
REIT shares represent private and public equity stock in companies that are structured
as trusts that invest in real estate, mortgages or other real estate collateralized
REITs typically own and operate real estate properties. These may include multifamily
residential properties, grocery-anchored shopping centers, local retail properties
and strip centers, malls, commercial office space, and hotels.
Real estate investment trusts are run by a board of directors that makes investment
management decisions on behalf of the trust. REITs pay little or no federal income
tax as long as they distribute 90% of taxable income as dividends to shareholders.
Even though the tax advantage increases after-tax cash flows, the inability for REITs
to retain cash can significantly hamper growth and long-term appreciation.
Apart from the tax advantage, REITs provide many of the same advantages and
disadvantages as equities.
REIT managers provide strategic vision and make the investment-and property-related
decisions, thus addressing management-related issues for investors.
The greatest disadvantages of REITs for retail investors are the difficulty of investing
with limited capital and the significant amount of asset-specific knowledge and analysis
required to select them and forecast their performance.
REIT investments have a much higher correlation to the overall stock market than
do direct real estate investments, which leads some to downplay their diversification
characteristics. Volatility in the REIT market has also been higher than in direct real
estate. This is due to the influence of macroeconomic forces on REIT values and
the fact that REIT stocks are continuously valued, while direct real estate is influenced
more by local property markets, and is valued using the appraisal method,
which tends to smooth investment returns.
Real Estate Mutual Funds
Real estate mutual funds invest primarily in REIT stocks and real estate operating
companies. They provide the ability to gain diversified exposure to real estate using
a relatively small amount of capital. Depending on their strategy and diversification
goals, they provide investors with a much broader asset selection than can be
achieved by buying REIT stocks alone, and also provide the flexibility of easily moving
from one fund to another. Flexibility is also advantageous to the mutual fund investor
because of the comparative ease in acquiring and disposing of assets on a systematic
and regulated exchange, as opposed to direct investing, which is arduous and expensive.
More speculative investors can tactically overweight certain property or regional
exposure in order to maximize return.
Creating exposure to a broad base of mutual funds can also reduce transaction
costs and commissions relative to buying individual REIT stocks.
Another significant advantage for retail investors is the analytical and research information
provided by the funds on acquired assets, as well as management's perspective on
the viability and performance of real estate, both as specific investments and as an
For investors without the desire, knowledge, or capital to buy land or property on
their own real estate funds allow to participate in the income and long-term growth
potential of real estate. Although real estate mutual funds bring liquidity to a traditionally
illiquid asset class, naysayers believe they cannot compare to direct investment in
Many retail investors who have not considered real estate allocations for their
investment portfolios fail to realize that they may already be investing in real estate
by owning a home. Not only do they already have real estate exposure,
most are also taking additional financial risk by having a home mortgage.
For the most part, this exposure has been beneficial, helping many amass the
capital required for retirement.