Passive fund investment set to boost private real estate market

Increased passive investment into real estate investment trusts (REITs) is set to drive a new wave of capital into private real estate markets and bring fundamental change to the US.

The US stock market has seen the launch of more passive funds in recent years. While active funds employ managers to pick shares, passive funds seek to replicate the performance of an index, such as the S&P 500 or a real estate index. 

Without the need to employ fund managers, passive funds offer lower fees and, in many cases, better performance – making them particularly attractive in times of economic uncertainty.

Like other sectors, the US real estate investment trust (REIT) sector has seen more investment from passive funds, and in 2019, passive funds held a greater share of REIT assets than active funds, 51 percent compared with 49 percent.

It’s bringing fundamental changes to US real estate capital markets, says Sheheryar Hafeez, managing director, M&A and corporate advisory at JLL. “A few years ago, passive funds were only about 20 to 30 percent of REIT investment,” he says. “As that has grown, we have seen changes in the market. Fewer active funds means fewer potential backers for an initial public offering (IPO), for example, as passive funds will only invest in REITs when they are listed. The US REIT IPO market has been fairly anaemic in recent years, and we have seen few billion-dollar floats.”

Many of the major real estate investors are exploring private market options, such as portfolio sales, funds and recapitalizations, says Hafeez. A further boost is the huge amount of capital which has been raised for private real estate investors in recent years. According to research house Preqin, US$187 billion was raised for private real estate in 2019, and global real estate funds had US$345 billion of dry powder at mid-year 2020. 

The greater involvement of passive funds in the US REIT market will have another, more subtle, effect, says Hafeez. “Widespread passive trading means that REITs will come to perform more like the stock market than the underlying real estate, which will dilute the impact REITs have on equity portfolios.”

Additionally, REIT volatility has been unexpectedly high this year. REITs tend to be less volatile than the wider stock market, however since the COIVD-19 outbreak they have become more volatile than the wider market.

Hafeez believes these factors will push more capital into private real estate, especially as private markets offer a range of ‘REIT-like’ options. For example, the US has a number of very large core open-ended real estate funds, which offer investors exposure to core assets and some liquidity.

The market upheaval caused by COVID-19 could also drive a new wave of private equity involvement in public real estate markets. Hafeez notes that US office REITs have been trading at a discount to net asset value for several years. “This reflects concerns about valuations, with the US market having been at or near the top for some years,” he says. “Now that we have a downswing, we expect to see more opportunities for private capital to play in the public markets.”