Real estate appeals to many clients because the investment has low correlations to the stock market. But most individual investors don’t have enough capital to get direct exposure to large commercial properties, such as office towers. In most cases, they’d have to buy a publicly traded REIT.
This is changing, says Sam Sivarajan, head of investments at Manulife Private Wealth in Toronto. He’s put clients into a new type of fund that allows wealthy individual investors to access direct buys made by institutional players.
It has a two-part structure. The first 75% to 85% is a portfolio of commercial properties. It’s held by a limited partnership comprised of pension funds and other institutional investors. The buy-in is up to $10 million and the lock-up period’s as much as 10 years.
Such terms normally cut off access to retail investors, but that problem’s solved by the fund’s other 15% to 25%. “In order to give access to private clients, who typically have shorter time horizons and need greater liquidity,” Sivarajan explains, “the managers created a liquidity pool that invests in publicly traded REITs and T-bills.”
This allows the fund to require a shorter, one-year lock-up for retail investors. When clients exit the fund, managers convert liquid securities to cash. “I always say, ‘Even though you’re locked in for a year, don’t think of this as a one-year investment.’ They have to look at it as a five-year investment.” The reason is market cycles typically last five to seven years, and it’s safer to be invested for a full cycle. That way, it becomes less important when the client gets in or out.
Typically, managers must hold at least 75% of the fund in real estate. “That’s important because the purpose of the fund is not to invest in that 15% to 25%. The presence of that liquidity pool is the trade-off retail clients have to accept to have easier access to their money.”
The liquidity pool does change the return profile for private clients. It may dampen overall returns, though the liquidity pool could outperform the private property portfolio, notes Sivarajan. Institutional clients, meanwhile, don’t invest in the liquidity pool.
“They don’t need shorter lock-ups and typically have set asset allocation targets.”
While the fund’s open-ended, managers aren’t always accepting retail money. “We’ve had to wait a couple months before we could subscribe on behalf of clients,” Sivarajan says. “When funds come in, the manager decides on the disbursement—how much goes to the liquidity pool, hard assets, new investments, maintenance, etc.” But, clients “participate in the overall returns of the fund, regardless of where their money’s deployed.”
The minimum buy-in for private clients is $1 million, and the allocation against their overall portfolios should be 5% to 10% (see “Client profile,” this page).
The fund’s diversified across 20 properties in four provinces and nine markets. There are three building types: office, retail and industrial. The average property is worth $30 million. Office towers are in major urban centres. They house tenants such as banks, law firms, doctors and dentists, who typically sign three- to five-year leases. Industrial and retail properties have the same requirement. These lease terms help stabilize yields.
The current occupancy rate of properties owned by the fund is 97%, though Sivarajan notes there’s no fixed target. The management team aims to balance occupancy and rental yields. A separate team of managers handles the liquidity pool. “They’re looking for REITs with good yield, but also good use of capital,” notes Sivarajan, adding that back in 2012, some REITs were borrowing money and overpaying for properties. Avoid those. Because most of the fund is illiquid, clients can’t know its current value as easily as with stocks. Sivarajan notes independent quarterly appraisals are done to determine net asset value. Managers give clients quarterly valuation reports based on these assessments.
Performance, fees & risk
Management fees for retail clients are between 1% and 2%. (Higher capital requirements and longer lock-ups mean lower fees for institutional clients.) And the fund manufacturer holds a large stake; that’s important, Sivarajan says, because it aligns everyone’s interests. Annual returns range from 7% to 15%, the most typical being 10% to 12%. Clients have the option to take or reinvest quarterly distributions; last year’s were about 3.5%. About 80% of performance comes from rental income. Because properties have high-quality tenants, rents keep flowing when the broader economy underperforms. Another source is profits from property sales. For instance, a manager may buy a property with the intention of holding it for five years. If at that time it’s a seller’s market, she’ll unload it and take the profit; if it’s a bad market, she’ll hang on and keep drawing rents.
A potential headwind is rising operating expenses. “There could also be an extended vacancy rate because of a glut in the market,” says Sivarajan, adding this was a problem in Toronto in the 1990s.
Clients face two main risks. One is illiquidity—the fact they’re locked in. Compared to stocks, the risk here is much higher because the client has to give the fund manager one year’s notice before the units will be bought back. The client’s only other option is to sell on a secondary market.
“In a secondary sale, there may be a haircut to NAV of 20% to 30%, though it really depends on market conditions.”
The other risk is capital loss. Sivarajan says compared to most commercial REITs, private real estate is more stable.
Client’s minimum investable assets: $10 million, although some clients with $5 million have invested
Characteristics: Accredited investor. Although Sivarajan’s clients are discretionary, they have to sign off on this investment
Objectives: Yield, diversification, inflation hedging