Getting there slowly.
Ed McCarthy | WealthManagement.com | Feb 27, 2018
Even after the markets’ early-February gyrations, U.S. stock prices are fully valued and possibly overvalued. Interest rates appear poised to move consistently higher, subsequently reducing bond returns. Given the potential for lower future returns from these two asset classes, is this the right time to pitch direct (i.e., private or not publicly traded) real estate investments to your defined contribution plan clients? Perhaps, but industry observers say it’s still early days.
The Case for Direct Real Estate
The argument for including direct real estate investments in DC plans is the same as for including real estate investments in any diversified portfolio. A white paper sponsored by the Defined Contribution Real Estate Council, an industry advocacy group headquartered in Ridgewood, N.J., makes the case that adding a direct real estate allocation to a traditional equity and fixed income portfolio improves the return profile. “There’s greater diversification, there’s less volatility and private equity real estate just offers a generally consistent income return that adds to that kind of consistent return profile that is the generator of lessening the volatility,” says Jennifer Perkins, DCERC co-president.
Allan Swaringen, DCERC co-president, notes that most of the real estate being considered for DC plans is core real estate, which by definition is lower risk, higher quality and lower volatility. About 65 percent of the returns over the last 20 years from core real estate have been from their income, making real estate a viable alternative investment for plan sponsors and beneficiaries. “I’d say the other big case for real estate as it relates to the income component is also real estate historically has been shown to be a nice inflation hedge,” he adds.
Swaringen points out that these characteristics describe direct real estate investments’ returns, not necessarily returns earned with real estate investment trusts called REITs. “In this time period right now of concern about rising interest rates, historically, real estate, not so much REITs but private direct real estate, has performed very well in rising inflationary environments,” he says.
A November 2014 report from Aon plc also highlights direct real estate investments. It points out that REITs’ shares can trade at substantial discounts and premiums to their assets’ underlying values: “... based on multiple non-real estate and broader stock market sentiment—creating a different return profile and offering fewer of the diversification benefits of private core real estate investments.”
The usual concerns cited for DC plans’ hesitance with direct real estate include liquidity, valuation and operational challenges. Real estate managers have made good progress on these concerns, Swaringen says. They now offer investment vehicles that provide daily net asset values and by combining direct real estate holdings with REIT positions, they can provide higher levels of liquidity. To enhance market tracking, the National Council of Real Estate Investment Fiduciaries (NCREIF.org) has created the NCREIF Property Index, described as “a quarterly index tracking the performance of core institutional property markets in the U.S.” Recordkeepers are also increasing their acceptance of direct real estate investments on their platforms, says Perkins.
Though some challenges remain. Russ Ivinjack, senior partner with Aon in Chicago, cites an operational difference with direct real estate investments that DC plan sponsors need to understand. He gives the example of a plan that has decided to invest $50 million in private market real estate. Unlike managers of a traditional asset class, the real estate managers are likely to call the capital over a period of time versus investing it immediately. For example, if the real estate investment begins Jan. 1, the fund manager might not call the initial funds for several months. “Operationally, most defined contribution plans are not used to a capital call structure like pension plans are,” says Ivinjack. “They’re usually saying if we’re going to invest $50 million January 1, that $50 million goes in January 1.”
Interest Growing Slowly
Although DC plan sponsors are moving at a “very deliberate pace,” plans with custom target-date funds and other white label funds are giving a “very positive reception” to the idea of including private market real estate, Ivinjack says. He expects adoption to accelerate as more real estate strategies surpass $1 billion of assets and can publish three years or more of investment results.
Perkins cites DECRC’s findings of “at least $25 billion in private equity real estate that’s been incorporated in what we’ve calculated as more than 100 defined contribution plans, which are then supported by 20 different consultants, 14 different recordkeepers and 10 custodians.”
Swaringen identifies two groups of early adopters. The first is large corporate plans that also have familiarity with private real estate through their defined benefit plans. The other pocket of interest is registered investment advisory firms for their own DC plans. “We’ve had some adoption from small RIA teams, registered investment advisor teams, who actually have their own 401(k) plan,” he says. “They are the sponsors for it and they’re the beneficiaries of it [and] we’ve seen early adoption [from] them too. So, it seems to be kind of barbelled.”
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