Private Real Estate: When Smooth Returns Mask Rough Risks
The popularity of private and alternative asset classes has heated up in the past decade – private core real‑estate income funds are one of the new cool things to own. The pitch is familiar – 6 to 8 percent yields, quarterly dividend/distribution cheques and valuations that barely move. Strip away any marketing shine, though, and the story looks a lot like stanard equity‑style risk, bond‑like upside and fees that never take a holiday.
What private real‑estate funds actually do:
Money is pooled, modest leverage is added (often 25–40 percent) and the manager buys office towers, industrial parks or apartment complexes that never show up inside a public REIT (Real Estate Investment Trust).
Investors receive appraisal‑based net‑asset values rather than live market prices, so unit values change only when a new appraisal lands – sometimes just once a year.
What the data say (not the marketing decks)
A pair of peer‑reviewed studies dig deeper into the data around these funds:
- “Real‑Estate Betas and the Implications for Asset Allocation,” Peter Mladina, 2019. Public REIT returns can be replicated by ~60 percent small‑cap value funds plus ~40 percent long‑term high‑yield bonds – meaning the premium investors enjoy is simply compensation for equity and credit risk.
-Simply put – you can seemingly get the same gross return with public equities / bonds for a significantly lower fee
- “Demystifying Illiquid Assets: Expected Returns for Private Real Estate,” Antti Ilmanen et al., 2020. Once private‑real‑estate returns are de‑smoothed, their correlation with broad equities jumps to 0.66 (almost the same 0.77 correlation they show with REITs). Any out‑performance disappears after adjusting for lagged REIT betas and leverage – suggesting no illiquidity premium, possibly even an illiquidity discount.
Some argue that the “illiquidity premium” is really a psychological fee for not seeing day-to-day price swings. Think of your house: if its value quietly slips 15-20% most owners don’t rush to sell (they only find out when the annual assessment arrives). The pitch is that you should pay extra for that same “calm in your portfolio” – but academic evidence shows the promised premium rarely materialises.
Why the ride feels so calm – until it doesn’t:
Appraisals are opinion‑based snapshots lagging real‑time market moves (think mid‑2023 office building writedowns that hit six months late).
The delay under‑reports volatility, inflates Sharpe ratios and misleads portfolio optimisers into recommending double‑digit portfolio weights (this is a good example of modelling only being as good as your data – and the need for the ‘human touch’). And then when forced sellers appear due to poor economic conditions, and their redemptions get gated, which happened at several Canadian open‑end real‑estate funds, true prices surface quickly.
Floating‑rate mortgages add another hidden lever. Rising rates lift net operating income more slowly than they raise interest expense, so debt coverage can shrink fast in a downturn.
Four questions to ask before buying bricks‑and‑mortar by proxy:
- What is the appraisal schedule and who hires the valuers (the manager or an independent committee)?
- How much leverage sits at the property level and at the fund level – and are the loans floating or fixed?
- What gates or hold‑back clauses govern redemptions (read the limited‑partnership agreement, not just the slide deck)? When can I take my money out, how much, if any, am I limited to taking at a time?
- Could a low‑cost blend of public REITs, small‑cap value equities and corporate bonds achieve the same expected return with daily liquidity and one‑tenth the fee? (hint: yes)
Takeaways:
- Appraisal smoothing is not risk reduction – it is delayed recognition.
- Academic evidence shows private real estate delivers the same factor exposure (the true drivers of excess returns) investors can buy cheaply and transparently in public markets.
- Illiquidity premiums remain elusive; illiquidity discounts appear real whenever gates go up.
For investors seeking true diversification, publicly traded assets priced in real time still offer the clearest picture of risk – and the easiest exit when the cycle turns.
Private Real Estate Investments and funds, and other investment strategies discussed may not be suitable for all investors. Investment decisions should be based on individual objectives, risk tolerance, time horizon, and financial circumstances.
Disclosures:
Important information about mutual funds is found in the Fund Facts document. Please read this carefully before investing. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated. Unit values and investment returns will fluctuate.
The information provided is based on current laws, regulations and other rules applicable to Canadian residents. It is accurate to the best of our knowledge as of the date of publication. Rules and their interpretation may change, affecting the accuracy of the information. The information provided is general in nature and should not be relied upon as a substitute for advice in any specific situation. For specific situations, advice should be obtained from the appropriate legal, accounting, tax or other professional advisors.
Stay diversified. Understand the fine print. Stay aware of the exit terms.
And remember: past stability doesn’t guarantee future liquidity.
