Registered investment advisors are consistently challenged with designing client portfolios that deliver sufficient returns while minimizing risk. This often requires finding alternative investment opportunities that will perform well under the different market conditions.
Historically, real estate has helped provide downside protection as well as income and capital preservation. Investing in private commercial real estate (CRE) may provide portfolio benefits, including diversification, attractive risk-adjusted returns, and a potential inflation hedge. This can make CRE a suitable addition to a traditional stock and bond portfolio. When building a real estate allocation in a client portfolio, it’s critical to understand the characteristics of the different CRE investment structures, which are often referred to as the four quadrants.
What Are the Quadrants of Real Estate Investing?
Commercial real estate investments are categorized as debt or equity and trade on a public security exchange (like the New York Stock Exchange) or are available in the private market. So, there are four distinct types of CRE:
- Private equity
- Public equity
- Private debt
- Public debt
Private Equity Real Estate
Private equity real estate refers to an investor taking an equity interest in a property or a portfolio of properties an investment manager has acquired using private capital. Some of the most common forms of private equity real estate include:
- Non-traded real estate investment trusts (REITs)
- Joint ventures
- Direct investments
- Separate accounts
Institutional and accredited investors may also invest in CRE using a professionally managed pool of capital, known as a commingled fund. These vehicles use a professional investment management firm (a general partner – or GP) to acquire, develop, manage, and dispose of real estate investments for the fund’s investors (limited partners – or LPs). By investing in the funds that own the properties, LPs participate in any appreciation of the properties.
Private Real Estate Debt
Most private real estate debt uses a comingled fund structure, pooling funds from a group of investors and investing in debt instruments that are either backed by or tied to CRE property.
Private real estate debt comingled funds provide financing to borrowers who can use it to buy, improve, or restructure their ownership in CRE properties. A GP manages the funds, and the fund’s investments receive fees and interest payments.
The primary types of private real estate debt include:
- Senior secured debt
- Mezzanine debt
- Preferred equity positions
Public Real Estate Debt
Public real estate debt is an investment that provides debt financing for CRE properties. The primary types of public real estate debt include:
- Commercial mortgage-backed securities (CMBS)
- Residential mortgage-backed securities (RMBS)
- Mortgage REITs
A CMBS is a pool of mortgages backed by commercial properties. An RMBS uses a similar structure but is backed by single-family homes. Both offer investors the choice of multiple tranches, each with a different payment priority and level of risk. Investors purchasing lower-priority tranches take on more risk but are also compensated with the potential for higher returns.
Mortgage REITs are similar to other types of REITs in that they pass the bulk of their income along to shareholders in the form of dividends. They own residential and commercial mortgage securities and are collateralized by real estate properties. Since they trade on a stock exchange, they’re also considered liquid investments.
Pulling it All Together
As you evaluate equity and debt strategies in both the public and private markets, it’s important to understand the potential benefits and limitations of each. Specifically, while private investments are generally considered illiquid, investors may earn a higher rate of return (known as an illiquidity premium) than with publicly-traded securities.
Conversely, while public investment strategies afford investors the advantage of liquidity, they may be exposed to other market influences and risks than private investment strategies which are generally considered a purer expression of real estate investing.
CRE can often be a suitable complement to a stock and bond portfolio by potentially reducing portfolio volatility, helping to protect against inflation, and providing an alternative source of income. When considering a CRE allocation for client portfolios, we encourage you to examine and understand each category’s risk/return characteristics to determine the strategy most suitable for a given client.
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