The REIT renaissance: An option to consider for accessing private real estate

A new allocation conversation

The 60/40 portfolio had always been considered, by many, to be a thoughtful portfolio allocation to traditional investments for individual investors based on the idea that stocks and bonds are generally uncorrelated to each other. Then 2022 turned all that on its head. After a 40-year peak of inflation, both stock and bond prices moved down simultaneously. One unintended outcome of that volatile market environment is that many investors are now more open-minded when it comes to refreshing their allocation percentages and considering alternative investments as part of their overall portfolio, such as private real estate.

Investors may be missing out

Real estate is one of the largest asset classes in the U.S. and the world—but it is missing in most 60/40 portfolios, with many individual investors perhaps unsure how to access it.

Stephen Morello, a principal in the Client and Partner Group at KKR*, says there are three main benefits of having private real estate in one’s portfolio: it can act as a hedge against inflation, it can provide uncorrelated returns to traditional investments, and it can provide tax-efficient income.

Publicly traded REITs (Real Estate Investment Trusts) have often been the default option for investors dipping their toes into real estate. But for investors looking for stability and diversification, this may not meet their needs, Morello says, noting that “Publicly traded REITs tend to cause outsized volatility due to their exchange-traded nature, which increases their correlation to publicly traded equities.”

Publicly traded REITs have generally been more volatile than private real estate due to their exchange-traded nature. The emotional experience of price swings in exchange-traded products may not align with investors looking for stability in their portfolios. For investors that can withstand illiquidity, non-traded REITs may be another option to consider for accessing private real estate.

While non-traded REITs do not have daily liquidity, they offer investors true exposure to private real estate. Because commercial real estate is an illiquid asset class, non-traded REITs tend to have the potential for either monthly or quarterly liquidity. “A non-traded REIT typically provides a percentage of the fund's NAV in liquidity for investors at a quarterly or monthly cadence, which is very different than the daily exchange traded liquidity of a publicly traded REIT.” he says.

In addition, tax efficiency can be an attractive aspect of an investment in real estate. Non-traded REITs have the ability to depreciate hard assets within their portfolio and pass through the benefit of that depreciation in the form of what’s called Return of Capital (ROC). This tax-deferred percentage of income can be quite high—even up to 100%. Anything that's not deemed ROC still receives another benefit under the Tax Cuts and Jobs Act of 2017, a 20% discount from an investor’s ordinary income tax bracket. As Morello explains, taking all of this into account, the entirety of the distribution of a non-traded REIT can be more tax-advantaged than investors’ ordinary income tax rate.

Not your grandfather’s REIT

Even with these advantages, Morello believes that some investors may have misconceptions of non-traded REITs—and with some validity. Non-traded REITs grew in popularity in the early 2000s and were marketed to retail investors by non-reputable firms, with non-standardized opaque valuation processes, and charged high upfront fees. During the global financial crisis, a lot of people lost a lot of money, leading to inherent skepticism around their structure and general terminology.

However, in the years since the Global Financial Crisis, Morello notes, non-traded REITs have evolved. Regulators stepped in. More well-known sponsors arrived. Now the space has become more institutionalized, with enhanced valuation processes, new structures, and a level of third-party oversight to add credibility to the structure.

City of the future

Many have speculated that the exodus of workers from city centers during the pandemic has crippled downtowns and weakened the value of real estate, but Morello doesn’t think the gloomy perspective of the “dead downtown” is necessarily correct. While total demand for older office buildings and those in non-prime locations has come down fairly significantly, the hybrid work environment is causing many companies to rethink their office footprint. They are often consolidating and downsizing into new tech-enabled offices in prime locations with lots of amenities near transit centers—where there is more resilient demand for these kinds of buildings.

“…the hybrid work environment is causing many companies to rethink their office footprint.”Transforming older, unused vacant office space will continue to have challenges; magically transforming office buildings into multifamily residential is not a silver bullet, Morello says. Many older office buildings have large floor plates that don’t necessarily align with the typical structure of a multifamily asset and lack requirements for a residential conversion, such as sufficient numbers of elevators or bedroom windows. Combined with the increased cost of financing, it's harder for developers now to achieve profitability in an office-to-multifamily conversion. “But looking over the next decade or two, while there will be less office space, we believe there will still be demand for housing in select cities, especially from young people,” Morello says.

Outside of prime locations, industrial warehouses are on the rise as part of the “Amazon effect”—where the growth of ecommerce is supporting industrial warehouse demand, says Morello. The products that people buy online have to be housed somewhere, and KKR believes that industrial warehouses will continue to be needed near highly populated areas.

Allocating for REITs

Every investor will have different needs or abilities to take on illiquidity and risks associated with real estate investing. Morello notes that investors whose risk tolerances and investment objectives, and are open to reallocating their 60/40 portfolio might consider a 40/30/30 portfolio with 30% allocated to alternative investments and 10% of the entire portfolio to private real estate.

“There are many different private market asset classes that would fall in the alternatives bucket: private real estate, private credit, private equity, and private infrastructure, just to name a few,” Morello says. In a recent test, he adds, KKR found that historically the 40/30/30 portfolio outperformed the 60/40 with far less volatility over the last 20 years, which creates a far better—and less emotional—return experience for the investor.**

As with other alternative investments, financial professionals may be required by their firms to receive additional education or training to sell non-listed REITs.