The stability of private real estate investment pools

When clients want real estate investment exposure without the hassle of being a landlord, they often default to REITs. But is there another alternative? Private investment real estate pools, often arranged as real estate limited partnerships (RELPs), are growing in popularity. Typically, RELP access has been limited to high-net-worth families, but these investments have recently become more accessible.

Unlike REITs, RELPs are not publicly traded. This makes them less liquid, but provides a return that more accurately reflects the value of the underlying real estate, which mitigates volatility. Figure 1 (this page) shows the difference in price volatility between directly invested properties (RELPs) and publicly traded ones (REITs).

Types of Canadian properties held in RELPs

RELPs and REITs are similar in that they invest in many of the same things, like office, retail, industrial or multi-family properties. Along the same lines, each RELP or REIT can have a different investment mandate and may specialize in a specific area, such as shopping centres in the retail sector. As with any investment, diversification is key, so investors should avoid being concentrated in any one property type. For example, a heavy weighting in retail would’ve been impacted by the recent shutdown of Target in Canada, a big anchor tenant for many shopping centres.

Also, RELPs don’t have to just hold income-producing properties. Certain investment structures focus on real estate development. Due to the speculative nature of development and the fact that there is no income at the onset, RELPs are higher risk.

The investment process

RELPs are limited partnerships (LPs) structured as either open or closed. Open-end LPs are open to new investments, allow redemptions (with applicable restrictions) and stay active as long as the LP agreement allows.

$1.5 million

The average worth of a wealthy Canadian’s home.

Source: BMO Private Banking

Closed-end LPs are partnerships with a defined life and committed investors, and little chance for redemption during the life of the partnership. These often raise funds in stages (which is called a close) and might have two or three closes until sufficient capital has been raised.

Assets are bought and sold according to the RELP’s investment guidelines and due diligence process, as outlined in the LP agreement or offering memorandum. For instance, the agreement could include a 10-year projection, with detailed modeling for tenant renewals, expenses, occupancy and amortization.

What are the fees?

With multiple categories of potential fees, certain RELPs can end up charging a high amount: particularly closed LPs, where funds are raised at the onset. Such fees can include acquisition, asset management, property management, project management, construction, disposition and financing, which can add up quickly.

Pay particular attention to whether fees are charged on capital raised, committed capital, utilized capital, net asset value or gross asset value. These factors can significantly affect the amount you are paying (e.g., paying fees on the net asset value will be less than the gross asset value).

What to look for

• Size: Having a sizeable AUM helps RELPs with flexibility when it comes to making purchases, and when, for instance, there is the loss of a major tenant (e.g., Target Canada).
• Consistency: Look for RELPs with steady growth, which means they’ve grown through patience and finding the right deals. There are many examples of RELPs that tried to grow too quickly and ended up acquiring assets in poor locations, on poor terms or in poor standing.
• Benchmarks: Since RELPs aren’t publicly traded, find out if they are tracking their value and performance through an international organization that benchmarks real estate performance, like the Investment Property Databank (now owned by MSCI).
• Risk and return: Do the RELPs own cash-flowing assets to sustain growth, or do they grow capital by building new properties? The latter situation comes with more risk, but the RELP’s managers could be good at what they do. Also note that the RELP’s risk level should not exceed an investor’s risk tolerance.
• Management team: What is their real estate experience? What is their track record over a 10-year period? Are they investing in the LP alongside investors? Do they have a team of experienced real estate professionals to support them, or is work outsourced to third parties?
• Liquidity: Generally, RELPs are less liquid than REITs, so RELPs are better for clients with long-term investment time horizons. The level of liquidity can vary—open RELPs can be easier to exit; closed LPs can be next to impossible to exit until completion. So, know what the exit options and penalties are.
• Distributions: What is the RELP’s distribution policy and history of distributions? Does it have a DRIP program?

Real estate is an important asset class to have in an investment portfolio. As investment managers, we hold both REITs and RELPs for diversification and different types of exposure. But, because the latter isn’t publicly traded, it can offer better value without the large swings in market volatility.

by David Sung, CFP, CLU, CIM, president, Nicola Wealth Management, and Wayman Crosby, RI(BC), PCC, managing partner, Nicola Crosby Real Estate Asset Management, a subsidiary of Nicola Wealth Management.