Over the last several years, the professionally invested real estate
market has increased in value dramatically. Publicly-traded REITs are up
on average through May 31, 2005 239% since January 1, 2000. Unfortunately,
this party appears to be nearing its end. However, a new way to play real
estate has been emerging for the past few years: the non-traded REIT and,
to a lesser degree, the real estate limited partnership. The new (old)
advantages are a steady stream of tax-sheltered cash flow and the
non-volatile nature of the investment (because it is in effect not priced
on anything resembling a regular basis). This type of investment is ideal
for a Lower Volatility Portfolio. However, the allocation of assets to
direct (illiquid) real estate investments without a clear understanding of
the benefits and risks nor obtaining the necessary additional return for
illiquid investments may make this a losing proposition.
Non-Traded Real Estate Offers Poor Returns on a Competitive Basis:
Physical investments in apartment buildings, commercial buildings and
other income-producing properties can be highly attractive from both a
return-on-investment and an income tax perspective for these investment
entities. Such properties, if they are available at the right price, can
produce substantial returns. However, therein lies the rub. Properties are
not available at great prices. Although many of these real estate
investment programs are now offered with substantially less up-front fees
as well as ongoing fees (if commissions are not being paid, then as much
as 96% of the investor’s dollars are available to invest in real
estate), they are probably still not worthwhile. Due to the current state
of property prices, cash flow yields on these programs will in all
likelihood max out at approximately six percent or perhaps even less.
Also, due to the fact that low, if any, leverage is used to purchase the
properties themselves, only minor appreciation is likely to occur.
Therefore, the income essentially becomes the total return. The problem
is, investors would not be compensated adequately for the illiquid nature
of these investment vehicles. What is fair compensation? We believe that
the additional return needs to be a minimum of five percent per year above
what a similar liquid investment would produce. Since publicly-traded
REITs are expected to earn four to five percent over the next decade the
illiquid real estate investments would need to provide a nine to ten
percent return annually. Given the above expected returns for illiquid
real estate investment vehicles, the equation does not balance. We would
vote to pass for now on this type of investment in most circumstances. The
lone exception would be if one were able to acquire an existing real
estate cash flow oriented program at a discount significant enough to
yield nine or ten percent to the acquirer. These investment opportunities
can sometimes be found on limited partnership secondary exchanges.
