Investing in Private Real Estate
Private real estate has long been the preserve of institutional investors, with allocations to the asset class growing to all-time highs this year.1
Now, high net worth investors have taken notice and are moving into the space. Recently enacted tax incentives for real estate investments in specific areas identified by the federal government, called Qualified Opportunity Zones, or QOZs, may accelerate interest among high net worth investors in adding private real estate to portfolios.
Private real estate offers the prospect of attractive risk-adjusted returns. Including 2004-2006 vintage funds, which weathered the bulk of the financial crisis, private real estate funds have an average net internal rate of return, or IRR, of 7.5% since 1993.2 Top quartile managers, the type of managers to which Evercore Wealth Management strives to allocate, typically return an additional 5.5% IRR above the average by vintage year. 2 These investments also provide an uncorrelated benefit against other assets in a typical investor’s portfolio, providing diversification. For example, the performance and valuation of a multifamily property in Atlanta has little to do with the performance and valuation of Apple stock. Diversification provided within the asset class is deep, as investors can invest across geographies, property types (office, multifamily housing, retail or industrial), and transaction sizes. And real estate has the potential to act as an inflation hedge, as rents are typically periodically adjusted to account for inflation.
When investing in private real estate, strong fund manager experience is crucial. A private real estate fund manager should have experience through multiple economic cycles, have a detailed knowledge of individual property characteristics, and possess the ability to capitalize on both broad and local market trends.
The private real estate market can be roughly broken up into three risk-return segments: Core/Core-Plus, Value-Add, and Development and Opportunistic.
Core/Core-Plus: This is the lowest risk segment of the market. The investment properties are stabilized, fully leased, and are typically located in major markets. Properties are often leased long term by high-quality tenants in desirable locations. Investments generate mostly predictable current income as opposed to capital appreciation. Target returns range from 6% to 10%, depending on the level of leverage used.
Value-Add: These are existing real estate properties that need light to moderate capital investment and/or market repositioning, usually applying a moderate amount of leverage, to improve rental rates and occupancy. Returns come in the form of a combination of increased cash flow and capital appreciation. Target returns for value-add real estate are 10%-15%. The value-add real estate space remains attractive in this investment environment, as skilled managers can find unique property improvement opportunities.
Development and Opportunistic: This segment of private equity real estate generally has the highest risk and therefore the highest return potential. Ground-up development, redevelopment, significant repositioning, special situations, and distressed investments are all categorized under opportunistic real estate. Managers take advantage of undeveloped land, undercapitalized assets, inefficient markets and information scarcity. Expected returns for opportunistic investments are 15% and more.
Over 8,700 distressed and low-income areas across the United States have been 63n designated as QOZs in connection with the Tax Cuts and Jobs Act of 2017, to encourage long-term economic development and revitalization in underdeveloped communities. Investors in QOZs may qualify for multiple tax benefits:
- Temporary deferral of capital gains tax from other investments (short- and long-term gains on the sale of stocks, bonds, mutual funds, property, and interests in partnerships)
- Partial step-up in basis of the capital gains invested into a QOZ, based on the length of the holding period
- Tax-free growth of the QOZ investment if held for at least 10 years
Assets within a QOZ must be put to new use or be substantially improved by investing at least the amount of the purchase price to further develop the site. For this reason, most QOZ investments will be in new development (ground-up construction) or in properties that need significant capital for redevelopment or repositioning. Managers of QOZ funds will develop and manage the QOZ properties over a 10+ year period; therefore many QOZ investments will start out as development projects but become stabilized core/core-plus assets over time. For this reason we prefer QOZ managers, such as CIM Group’s “build-to-core” strategy discussed in our Q&A with CIM Group, which are vertically integrated in-house, meaning that they have internal teams to conduct the development, construction management, leasing, and property management.
Investors considering a QOZ investment should consult with their tax advisor. As described below, the QOZ program has strict rules regarding the timing and implementation of investments in order to qualify for the tax incentives. The QOZ tax incentives can enhance after-tax returns for investors, Q&A with GIM Group.
Minding Your QOZs: Rules on Timing & Implementation3
1. An investor has 180 days after the sale of an asset to roll the capital gains into a Qualified Opportunity Fund, or QOF. The investor defers paying the capital gains tax on the reinvested earnings.
2. The QOF manager has 30 months to develop or redevelop the QOZ property, and is required to substantially improve the property by making a further investment into the property to double the adjusted basis (excluding cost of the land).
3. If the investment in the is made prior to the end of year 2019 and is held for seven years through December 2026, the investor receives a step-up in basis of 15%. If the investment is made prior to the end of year 2021 and is held for five years through December 2026, the step-up in basis is 10%. (Investments in QOFs made after 2021 will still defer payment of the capital gains tax until 2026, but will not receive a step-up in basis.)
4. In 2026 the investor pays the capital gains tax on the amount that was deferred (taxes likely due April 15, 2027).
5. After 10 years, investor pays no capital gains tax on the appreciation earned on their QOF investment. The investor is still responsible for taxes on the income from the properties, although a portion may be shielded by depreciation of the real estate asset.
Stephanie Hackett is a Partner and Portfolio Manager at Evercore Wealth Management. She can be contacted at email@example.com. Jake Stoiber contributed to this article.
2 Cambridge Associates. Real Estate Index and Benchmark Statistics. December 31, 2018.
3 Evercore’s research and recommendation is based on current QOZ proposed regulations released April 17, 2019 (Internal Revenue Service – www.irs.gov (IRC Section 1400Z-2)). An initial set of proposed regulations issued in October 2018 were also reviewed. Final regulations from IRS have not yet been issued. This information is not to be construed as tax advice; please consult your tax advisor prior to investing regarding your specific tax consequences.
IRS Circular 230 Disclosure:
Pursuant to IRS Regulations, we inform you that any U.S. Federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for (i) the purpose of avoiding IRS imposed penalties or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. This information is provided for information purposes only and does not constitute financial, investment, tax or legal advice.
©2016 Evercore Wealth Management LLC. All rights reserved.