Why are asset managers (privately) considering public real estate investment strategies?

Small things can have non-linear effects on a complex system.

While this sentence may not immediately resonate with the reader, the term “butterfly effect” (such as where a butterfly flapping its wings in, say, Mexico City, may trigger an earthquake or tsunami somewhere like, say, Japan) will surely be more evocative.

The allusion is to the possible links between two uncorrelated factors (or factors where there is no logical relationship). The “butterfly effect” can of course be misunderstood, as there is not always a proven, direct cause between the two factors. However, it does illuminate how what initially seems to be a minor, insignificant factor can heavily influence a course of events.

The real estate “butterfly effect”

For the purposes of this article, the butterfly effect illustrates how, out of nowhere, a pandemic has led to a (possibly temporary) shift in investment trends for the real estate asset class.

The choice between investing in listed or privately held real estate has always been a well-known conundrum for investors. It is a proven fact that, either way, investing in real estate brings about an often needed diversification “bonus” to every asset portfolio, in terms of quantum of earnings or a robust counterweight against liquidity.

Some investors have passionately held views on the merits of investing in publicly or privately held immovable assets, believing that one or the other delivers better investment multiples, more liquidity, faster returns or even a further layer of diversification by considering different real estate strategies instead of just a broader choice between real estate and, say, infrastructure investments.

In contrast to the increased interest in private debt (which is expected to receive a boost over the next few months), the global COVID-19 pandemic has had a negative impact on the real estate asset class. With the advent of lockdowns, real estate visits are no longer possible. Bans on non-essential activity have halted or limited construction works. No business means no cash—and cash is king in honoring accruals, rental payments and the like—the basic elements of investor IRR. 

Over the course of a few weeks, pandemic response measures have slowly but steadily immobilized what was previously considered a stable asset class, to the point where firming up an asset valuation or acquisition decision was a pointless exercise for most asset managers (due to uncontrollable market variables).

Why invest in listed real estate?

Whatever the asset class, managers need to generate IRR for their investors. “Blessed” with adversity, managers therefore need to quickly rethink their mainstream real estate investment strategies or (which may be an equally valid approach) wait for the tsunami to pass and put their business on hold.

With conditions unknown and uncertainty high, managers need to find a way to take the market’s pulse. What better way to do so than to look to real estate assets?

For some (i.e., those needing to show deployed commitments, despite the pandemic), the choice was unavoidable. Through public trading, listed real estate can give us a better handle on the fluctuations that have happened since the early weeks of March, and will enable these bets to bear fruit in the coming months.

It is of course an opportunistic move to opt for this type of investment to gain a clearer view on how the real estate market is reacting to all the butterfly wings flapping around the world.

Listed real estate has also been recognized as a long-term play in real estate investing; it is considered a stable investment. According to EPRA (European Public Real Estate Association), it is as stable over the long term as government bonds or mainstream listed equities. It provides immediate liquidity as it is traded on a stock market, and therefore removes the need to decide whether to go for open-ended or close-ended funds (highly pertinent in today’s climate). And it provides much sought-after asset diversification (at multiple levels, depending on how eclectic you are in your real estate investment choices), plus a steady return.

It may well be a good investment move in this time of uncertainty.

Why can tax stand in the way?

A word to the wise though: investors have been investing in private real estate for the past decade. This is the most stable and reliable asset class in the alternative investment fund industry. The private real asset universe has rules, mantras, principles and structures that are widely used and which we may be tempted to apply to listed real estate too.

However, although the underlying asset held is of the same nature and the exposure is essentially equivalent, investing in public real estate may have different tax implications. To note just a few:

• Publicly listed real estate investment vehicles are often incorporated under special regimes approved by the jurisdiction in which the asset is located. Real Estate Investment Funds/Trusts (REIFs/REITs) follow specific rules and may have different tax regimes where jurisdictions are looking to promote foreign investment, while not missing out on taxation of local gains. Hence, what you will be holding is a different type of investment entity than your usual property-owning company, with rules and regimes you might not have encountered before.
• Investment tickets for these entities are often smaller, so legal and economic ownership means a lower relative percentage. Where a significant or majority stake is less likely, the tax benefits typically linked to these may not materialize. The requirement to pay tax on these holdings where an exemption would typically apply in the private investment world may be detrimental to the IRR calculated at entry level.
• Profit repatriation is another issue to be concerned about. The double tax treaty system and tax-related European directives (i.e., those pertaining to the free movement of capital) may not necessarily apply to REIFs or REITS. This is because of a lack of harmonization both at EU and international level for these types of vehicles, making them ineligible for the related tax benefits due to features specific to individual countries.
• Investor profile: traditionally, the real estate asset class has been mostly the preserve of institutional investors. These are largely pension funds, insurance companies and banks, which, essentially, invest savings. Will these investors want to see managers making massive allocations to listed assets knowing that today’s top performers can be tomorrow’s laggards? We are writing this article the day after the price of an oil futures contract dropped below US$30 a barrel…need we say more?

Real estate investment is not a linear model. It is subject to as many fluctuations and shifts as other state-of-the-art alternative asset classes. This reality has been submerged by years of successful investor IRRs and fundraising after the 2008 financial crisis. The truth of the matter is that as stable as it may be, real estate relates to every human interaction, it has indirect links with all market activities and functions, and it can withstand enormous pressure in times of economic stability or uncertainty.

A successful investment strategy must therefore also consider tax. A step in the wrong direction, as alluded to above, and the expected return may not materialize.