Beyond the Backyard
The following article, written by Michael Finnigan, appeared in the CampdenFB magazine on March 18, 2016
Real estate is an emotional investment for many family office principals. Ask them to discuss their portfolios and they are more likely to tell you about their $10 million investment in a residential property than their ‘cash cow’ allocation to hedge funds. It’s the type of asset you’d expect to appeal to individuals who have built their businesses around family. But has the desire for real assets, particularly residential investments, caused an imbalance in portfolios?
According to the Global Family Office Report 2015, which surveyed 225 offices across the world, there was an on-going affinity for holding residential properties in portfolios over the past year, with 42% of direct investment going to the asset type. The report also revealed a disproportionate home bias for all real estate investments. Those offices that broke ranks and invested further afield chose top tier cities such as London and New York in order to snap up “trophy properties” in the world’s most desirable real estate markets, once again demonstrating the emotional pull of real estate among families.
Why does this matter when actual returns for real estate in 2015 were just above 14%, in turn helping European family offices to produce the highest year-on-year returns of all regions (6.4% in dollar terms) thanks to their significant holdings? According to Basil Demeroutis, managing partner at Fore Partnership, a co-investing platform that allows families to club together to purchase predominantly commercial property, a lack of diversification in an increasingly fluctuating real estate market could mean storm clouds on the horizon.
“The problem is that many family offices suffer from a lack of diversification. It is a key reason why families invest in real estate to begin with: to provide some balance in the portfolio, secure long-term income, a bit of inflation protection, and wealth transfer from generation to generation. If you’re only investing in skyscrapers in, say, Frankfurt, there will be a time when that doesn’t look like such a clever thing to do and maybe that investment in Berlin would provide a bit of diversification.”
With this in mind, CampdenFO has looked at a number of ways families could consider tweaking their real estate portfolios.
Demeroutis says family offices are doing well out of their current real estate strategies, however he suggests that the first step towards a more diversified portfolio might be to invest in second-tier cities, rather than capital cities, in order to shift focus away from domestic markets.
Liam Bailey, global head of research at property consultant Knight Frank, says the opportunities in second-tier cities are becoming particularly apparent now that the economy is recovering from the global financial crisis. “Take the UK as an example, if you compare Manchester and Birmingham against London, the real estate market remains around the same level as it was in 2007. In London prices have increased by 40%. That growth and economic activity is beginning to seep down into the second-tier cities. So I think there’s an opportunity in terms of stronger growth over the next five years for those locations,” Bailey explains.
While offices are likely aware of the opportunities in second-tier cities, Bailey says that they are principally attracted to primary cities as they offer long-term benchmarking information, which in turn makes it easier for them to check the performance of their investments. Another reason for their investment strategy is because of the large degree of activity in top-tier cities, which he says makes it easier for offices to enter or exit the market at a time of their choosing.
The typical investment horizon for real estate differs depending on whether the property is commercial or residential as well as on its location, according to the Global Family Office Report 2015, which broke down investment horizons for real estate by local, regional and international markets.
Key findings from the report suggest that almost half of family offices prefer to hold their residential properties for more than 10 years if it was in their local market, compared to three to six years for commercial properties. International investments in real estate were typically held for less than three years and made up around one third of the average portfolio.
This preference for residential property is the result of past experience and the emotional appeal of homes, according to the second annual Global Family Office Report, with 42% of real estate direct investments in residential property. The appeal of local areas was attributed to the skill set of the in-house team, who the report says are better equipped to manage local investments. Liam Bailey explains why family offices are beginning to look for opportunities further afield.
“While family offices have not been particularly active in secondary markets over the last five years, I think there is a much more open view, for example, of the logistics and office sectors. My suspicion is that you will see more activity in the regional cities for residential investment because there is recognition that you can receive greater yields. That holds true globally,” Bailey notes.
Bailey explains that one advantage of choosing a second-tier city is that the entry point is going to be cheaper and the property is likely to be in the centre of the city. By investing in these areas, family offices can broaden their portfolios in terms of geographical spread and number of units and gain access to a new market, he says.
So what steps should a family office take when investing in second-tier cities? Bailey believes they should first decide whether they’re making a long-term investment and whether the property will be used for residential or commercial purposes. Most importantly he says offices should conduct due diligence on the local economy in order to find success with their investments.
Due diligence was identified as an area for improvement among offices in a real estate report produced by the World Economic Forum in 2015. According to their report, The Advancement of Real Estate as a Global Asset, real estate investment in second-tier cities was most apparent in Europe, where the number of transactions in London and Paris dropped 17% year-on-year, compared to increases of 37% in the next 20 cities.
This interest in second-tier cities can also be seen in the real estate markets of the United States, according to global real estate service provider Savills. Their annual Winning in Growth Cities report suggests that investors with full “trophy asset” portfolios are looking with more interest at the yields available in second-tier cities that have not yet seen substantial capital growth.
China is also recognising the value of investing in second-tier cities, in order to keep up with rapid urbanisation. China’s second-tier cities dwarf the rest of the world’s, not just in size but also in youth, and are increasingly attractive to investors.
Bailey believes the interest in second-tier cities can be partly explained by national investment in infrastructure. He explains: “If you look at a city like Manchester, you’ve got a very compelling story. It’s a city that has successfully broadened its employment base over the past decade. It has a big media and technology hub thanks to BBC and ITV investment. Like so many second-tier cities the appeal is a broad spread of economic activity and growth.”
Investment in second-tier cities does not have to be limited to domestic markets but more often than not family offices are reluctant to invest abroad. One finding from the Global Family Office Report 2015 suggests this is because of the additional cost of outsourcing requirements and suggests that they will only make the investment if there is an expectation that returns will be higher than at home.
Bailey believes that family offices are more reluctant to invest abroad than at home because it requires a large commitment in terms of core skills from the family office. At home, the accessibility, practicality and time spent is lessened in local markets and therefore makes them more attractive.
Dani Evanson, managing director with RMA, a California-based real estate investment and advisory firm that caters to family offices and wealth management firms, is inclined to agree. She has seen an increasing number of offices investing with local operators or fund managers when deploying capital abroad.
“It absolutely makes sense for families with no in-house expertise to invest with local operators or fund managers. Other families require liquid strategies and depend on real estate investment trusts (REITs) for real estate exposure. The bottom line is that you need to know what you’re investing in and if not then it is important to target the best fund manager or operator for that region and product type,” she explains.
While Evanson says that top-tier cities offer families with long-term and stable exposure to real estate, she also recognises the growing opportunities in second-tier cities both at home and abroad.
“Many investors focus on core markets because they exhibit the least pricing volatility. However if you’re overpaying for location security, what kind of return on your investment can you really expect?” she asks. “Family offices need to understand that with second-tier markets comes more due diligence and competence, but also the possibility of greater returns.”
Co-investing is another real estate strategy that is finding traction with many family offices, particularly at Fore Partnership, the real estate business run by Demeroutis. After nearly two decades in the real estate business, the Cornell University graduate founded the business in 2012 founded on the principle of co-investment and offers families an innovative way of investing in real estate, through what Demeroutis calls “responsible real estate”.
To date the firm has closed two major projects, including a 50,000 sq ft Grade-A office building overlooking the River Thames in London and a 110,000 sq ft residential property in Berlin. In December 2015, it purchased a 48,160 sq ft building in Manchester.
Fore’s ‘responsible real estate’ strategy is intended to help families unlock additional value in commercial properties through an innovative approach to design and sustainability. It highlights one approach that might help families mitigate risk when investing abroad.
Demeroutis explains the concept: “We coined the term ‘responsible real estate’ to describe developments that embody traditional sustainability, such as energy, water, and low carbon strategies, but also elements of creative design that foster creativity. By creating modern work spaces that fit with the way people want to work we can help companies with the war on talent,” he says.
The approach could be particularly useful if the real estate market starts to slow down, according to Demeroutis. “We believe that the ‘green credentials’ of a building helps occupiers to improve their businesses, retain employees, clients, and their customers. They may even begin to consider sustainability as an extension of their brand. If that’s the case then they’re more likely to stay in our building and therefore they will be more likely to sell it,” Demeroutis explains.
Even under good market conditions the buzz surrounding the building’s green credentials led Fore to an early sale that delivered almost double the forecasted returns.
REITs are another strategy finding traction among family offices. According to the Global Family Office Report 2015, REITS performed particularly well in 2015 thanks to a reduced supply of commercial real estate properties brought about by the global financial crisis. Although they form a small proportion of an average family office portfolio (1%) with a 13% likelihood of inclusion. As the economy rebounds the scarcity of commercial properties has boosted REITs’ pricing power and could net significant returns for families, according to Bailey.
“I think the strong performance of REITs could also be a reflection of the skill sets needed to invest in property,” Bailey explains. “If you can identify a property where you know you can add value through careful management then the direct approach is an attractive prospect. Alternatively there are families who do not have such resources and in that case REIT offers good exposure to real estate.”
REITs are particularly sensitive to rising interest rates. Since the 2008 financial crisis both the US and UK have set historically low interest rates (near zero) to aid economic recovery. If interest rates increase as expected in mid-2016, REITs may become less attractive to investors, as dividend pay-outs will be lessened. Bailey argues that increasing rates will be mild and are indicative of an improving economy, which in turn means greater demand for commercial properties.
Demeroutis explains: “We’ve been saying for the last three and a half years that interest rates are staying lower for longer. Each year the Bank of England has pushed the date for interest rate rises. Even when they eventually start to go up it will only be around 5%. We need to have twenty quarters of 25 basis point increases in bank rates until we get back to what is even average, and I just don’t see that happening.”
While Demeroutis expects moderate increases in rates from both the US and UK, he says that rates are actually decreasing in Europe. “What that means for real estate is that a wall of capital will continue to flow towards the asset class because of the distorting actions of central bankers,” he explains. “The only negative aspect of real estate is that it’s expensive, but fundamentally I think it’s in very good shape. Rising rents, rising employment, which is very highly correlated to rising gross domestic product, means the only worry for investors is to not over pay for their properties.”
Global property company Savills tells a different story in a trading update released in January, warning of an impending slowdown in real estate transactions in some markets. The London-headquartered firm revealed it was only able to beat expectations for the year thanks to the sale of its real estate complex at Berlin’s Potsdamer Platz – a €1.3 billion ($1.4 billion) December deal that was part of a series of German disposals. It cautioned that rising interest rates could hinder profit moving forward.
Rival commercial real estate company Colliers echoed this uncertainty in the real estate market in its 2016 Global Investor Outlook report, finding that risk appetite among global real estate investors has declined over the past year. The report, which surveyed more than 600 global real estate investors, cited market weakness in China and geopolitical turmoil as the main reasons for investors’ increasingly cautious strategies.
Andy Hart, managing partner at US independent wealth advisory firm Delegate Advisors, outlines why the real estate market might not be as stable as one might imagine. “Right now the general temperament is ‘risk-off’ because people are worried about global growth relative to China. Core real estate also has a relatively low yield at the moment and we’re not attracted to it because of rising interest rates. There are simply other assets that are better able to produce higher risk-adjusted returns,” he explains.
Hart points out that another major concern for Delegate Advisors is a pullback in the US oil and gas industry that is likely to have a knock-on impact on the real estate market. “A lot of the firms that are oil producers had hedges on that protected them from the downturn, so you’re likely facing good buying opportunities in sectors that are subject to economic risk factors tied to the oil and gas business, much like we had in the 1980s. We’ve been keeping our eye out for that opportunity but we’d like to see those scenarios play out,” he adds.
The former adviser at Silicon Valley based wealth adviser Brownson, Rehmus & Foxworth added that he currently advises clients to be “patient and opportunistic” when considering real estate investments. The best opportunities he says are currently in Class-C real estate or in second- or third-tier cities, rather than overpriced top-tier markets.
“We’ve seen a significant amount of inflation in the pricing of high-end real estate in certain markets like New York and London. I live in San Francisco and I see it every day. The amount of push in pricing that’s occurring here is noteworthy and largely linked to the tech market in San Francisco. We’ve also see a lot of inflows of non-US investors in real estate buying homes in the Bay Area. So apartment prices here and real estate prices here are becoming unaffordable for the average worker. That’s a huge cause for concern.”
The University of Texas graduate concluded that real estate would likely remain an attractive asset for family offices in the US because it is a tax-advantaged asset. He says families may utilise section 1031 of the US Internal Revenue Code to roll the gain from one property into another qualifying property. The idea is to defer capital gains taxation. If these exchanges are utilised until the death of the property owner, the capital gain may be eliminated altogether. In other words, a property would then pass without an income tax burden to the next generation. The danger, he says, is that improper succession planning can force families to sell off their real estate during poor market conditions upon the death of a patriarch in order to pay the estate transfer tax.
So whether the investment is at home or abroad, in the commercial or residential space, or even laden with solar panels, it appears that family offices are likely to continue investing in real estate, despite rising interest rates. But as Demeroutis concludes: “A little diversification wouldn’t go amiss.”