Commercial Real Estate and Other Alternative Investments
You may hear the word “diversify” a lot today. As an investing term, it comes into play when you rebalance portfolio assets. However, it means a great deal more than just the avoidance of holding too long of a position in a particular stock.
I will get into why diversification is especially important now, amid today’s volatile markets in a moment. In the meantime, you need to know that it involves—not just a variety of traditional investments—but alternative investments, such as commercial real estate, as well.
Alternative investments are financial assets outside of the traditional investment categories (public equities, bonds, cash). As such, a wide array of investments fall into this category, such as private equity, venture capital, hedge funds, commodities, and even fine art and collectibles.
These types of investments are typically less easy to access and oftentimes can have higher fees than public investments.
This guide goes over some of the common features of alternative investments and the common reasons why one might add them to their portfolio. We’ll also explore a few specific types of alternative investments.
Alternative investments can typically be a good option to diversify your investment portfolio. It is prudent to hold investments that react differently to various events, e.g. interest rate hikes. Stated simply, you want some investments to zig when others zag. These uncorrelated movements help to lower the overall risk of your portfolio.
To illustrate portfolio diversification, it is logical that the performance of an apartment complex in Franklin, TN is not directly correlated to a public equity portfolio. The local economy, employment opportunities, area median income, and other factors are at play that more directly impact economic performance of an apartment complex. It is true that this relationship would represent some correlation to public equities, but there are many examples of assets that have little correlation or even negative correlation to public markets.
Adding alternative investments to your portfolio can make your portfolio more resilient in times of public equity distress or recessions.
Alternative investments may also be targeted to provide return enhancement to the portfolio. The venture capital space is one area that has historically provided outsized returns relative to public equity markets. Investing in early-stage companies is not without risk as many small businesses fail often.
But, when several are combined into a fund, a few success stories can produce large investment gains and offset losses in other companies.
It is important to size investments accordingly to achieve the right risk and return balance.
Private, closed-end investment strategies, such as private equity and venture capital, have long been a portfolio staple of institutional investors (pensions, endowments, family offices). These institutions are sophisticated and have investment teams dedicated to researching market trends and allocating to successful private fund managers.
Additionally, these institutions are sophisticated and have investment teams dedicated to researching market trends and allocating to successful private fund managers. Additionally, these institutions meet asset requirements that allow them to invest in most any asset class within their investment policy statement.
In addition to these financial requirements, individual investors must assess what portion of their net worth should be locked into private vehicles for up to 10 years.
Not only must you be an accredited investor or qualified purchaser, but many private investment funds also often require high investment minimums, typically $250,000 or more. This obviously limits the number of people who can invest in such a diversified manner.
In addition to the financial requirements, individual investors must determine what portion of their net worth can be inaccessible for a period of years. One of the drawbacks of private placement offerings is long lock-up period. Depending on the strategy, private vehicles can have lock-up periods of one to ten years, sometimes longer. Investors in these strategies demand a higher potential return, often referred to as the illiquidity premium. The strategies listed below (Commercial real estate, private equity/debt, and venture capital) are typically accessed via private placement structures subject to the aforementioned illiquidity.
There are liquid alternative investment strategies offered in more traditional investment vehicles, such as mutual funds and ETFs. These assets are more easily accessible to retail investors, often with low minimum investments and daily liquidity. Although the underlying investment strategies may be different from a traditional US equity fund, they can trade in similar ways.
In addition, there are hybrid structures such as interval funds. Interval funds blend characteristics of private placements and mutual funds. Often, these funds can be purchased on a frequent basis while offering quarterly redemptions. The redemptions are limited to a set amount or percentage of shares.
These attributes allow funds to hold a mix of liquid and illiquid securities. Determining what portion of your capital to allocate across different time frames is key to successful outcomes.
There are many ways to invest in commercial real estate, in both the debt and the equity side of the capital stack. Commercial real estate investments can be made in several different property types. The most common are office, retail, industrial, multifamily, or hotel properties. Investments can be made across the risk-return spectrum from core real estate to opportunistic, ground-up development projects.
Commercial real estate can be a source of income for investors. For instance, a typical office building is comprised of many tenants. These tenants sign a lease, usually for several years, to rent office space. At the same time, some commercial properties yield additional income from amenities, including vending machines, laundry facilities, and parking. All of these can combine with rent to increase the net operating income (NOI), which can appreciate, driving up local property values.
The scarcity of property in some areas is a given, while at the same time, growing companies will still need additional space. Especially when a property is located in a densely-populated commercial center, this limited supply tends to coincide with increasing demand, appreciating area real estate prices. Bear markets can do little, if anything whatsoever, to hinder that.
Additionally, and especially relevant in today’s environment, commercial real estate often serves as a hedge against inflation. Using the same office building example above, tenants usually sign lease agreements with rental rates that increase over time, say 2% per year. Moreover, as tenants end their lease agreements, new tenants are sought at higher rental rates. Staggering the rent roll of the tenant base allows the pricing to reset on a frequent basis, often matching or exceeding the pace of inflation.
Private equity and private debt are alternative ways to finance companies away from the public markets. Many large investment firms specialize in these types of investments, earning revenue by charging a management fee and incentive fees tied to the performance of their investments. Private equity investments can take many forms.
Growth equity investments are made in companies relatively early in their lifecycle, providing capital to fuel growth. The growth can be achieved by adding new executives, investing in new product lines, or acquiring competitors. In exchange for providing the growth capital, private equity funds take ownership in the company and typically have a seat on the board of directors. Conversely, a public company can be acquired and taken private.
Growth equity and buyout investments can include minority or majority ownership in the underlying business. Private debt investments can provide similar growth capital to private companies. As you can guess by the name, these investments take the form of loans in lieu of equity ownership. These debt instruments are traditionally higher yielding than bank loans and can include some form of equity upside, usually in the form of warrants.
Venture capital (VC) is a form of private equity aimed at early-stage companies. Venture capitalists aim to purchase minority ownership in several companies, usually in a sector where the VC firm has expertise, e.g., health care technology. VCs provide growth capital for companies as they determine product-market fit and hopefully scale their business.
Later rounds of capital may be raised to expand into new markets and/or new product categories. Early-stage venture capitalists may exit their investment in subsequent investment rounds, or they may elect to add new capital in each investment round. Exits can occur when shares are sold in a new investment round or if a company pursues an initial public offering (IPO).
Early-stage venture capitalists may exit their investment in subsequent investment rounds, or they may elect to add new capital in each investment round. Exits can occur when shares are sold in a new investment round or if a company pursues an initial public offering (IPO).
Venture capital investment returns have historically outpaced other asset classes, including public equities. Investments in early stage companies is not for the faint at hearth, though, as many investments will ultimately be unsuccessful. It is important to partner with VCs who have a history of providing strong returns to their investors as there is great dispersion among venture capital funds.
TrustCore has utilized alternative investments in our comprehensive investment strategies for decades. We have a strong network and a variety of investment options to augment client portfolios.
We specialize in helping people reach their financial goals and retirement plans, also. This is only one of many reasons to make us your financial advisor in Brentwood, TN, or wherever you are. You can schedule your complimentary appointment today for a face-to-face discussion of our financial services.
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