How is the current challenging economic environment impacting private markets? The Franklin Templeton Institute hosted a webinar with Tim Wang, Head of Investment Research at Clarion Partners, which invests in private real estate, and Rich Byrne, Senior Managing Director at Benefit Street Partners (BSP), a private credit investor. Here are my key takeaways:
- Institutions on average have about 11% of their portfolios in private real estate.1 While the current levels of inflation and the possibility of recession are challenging for real estate investors, Clarion thinks that industrial warehouses, life science facilities, and multi-family rental properties can provide strong returns as well as hedge against inflation. Most retail and office space properties will face difficulties in this environment.
- Publicly traded real estate investment trusts (REITs) are approximately 15% of the total investable real estate universe2 and they are highly correlated to equities. Private real estate provides a diversification benefit relative to stocks and bonds.
- The modern private credit market emerged after the Global Financial Crisis (GFC) to fill the void left by banks that significantly reduced their lending to small- and medium-sized businesses. The sector is benchmarked to high-yield debt based on its perceived risk profile, and generally prices its debt at a 150 basis-point premium to syndicated loans.
- Higher interest rates and inflation make floating-rate private credit more appealing. In this challenging environment, private credit providers, like BSP, can require stricter requirements on loan documentation and higher equity cushions (lower loan-to-value). These give investors higher yields that float as interest rates change and a lower risk profile.
- As interest rates rise it is a better time to be a lender. Current pricing in both private credit and private real estate debt is priced to compensate investors for the added risk of increased defaults.
Private markets can offer direct exposure to sectors of the economy that differ from public markets. This can help reduce the volatility in a portfolio that contains publicly traded securities, which are often subject to extreme swings in sentiment regardless of the underlying fundamentals.
WHAT ARE THE RISKS?
All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stocks historically have outperformed other asset classes over the long term but tend to fluctuate more dramatically over the short term. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds adjust to a rise in interest rates, the share price may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments; investments in emerging markets involve heightened risks related to the same factors. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.
The risks associated with a real estate strategy include, but are not limited to various risks inherent in the ownership of real estate property, such as fluctuations in lease occupancy rates and operating expenses, variations in rental schedules, which in turn may be adversely affected by general and local economic conditions, the supply and demand for real estate properties, zoning laws, rent control laws, real property taxes, the availability and costs of financing, environmental laws, and uninsured losses (generally from catastrophic events such as earthquakes, floods and wars).
Investments in alternative investment strategies are complex and speculative investments, entail significant risk and should not be considered a complete investment program. Depending on the product invested in, an investment in alternative investments may provide for only limited liquidity and is suitable only for persons who can afford to lose the entire amount of their investment.
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1. Source: 2021 Institutional Real Estate Allocations Monitor report.
2. Source: CBRE report (Global Investable Universe H2 2022) and NAREIT.