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Blackstone aside, is private equity real estate value for money?

The industry would be better served if performance was unbundled from the effects of leverage, argues Joseph L. Pagliari, Jr., clinical professor of real estate at the University of Chicago Booth School of Business.

The April issue of PERE included an interview with Jon Gray of Blackstone, in which he pushed back on a number of the common criticisms aimed at private equity.

I will leave it to others to comment on leveraged buyouts, venture capital and other forms of non-real estate private equity. However, I would like to comment specifically on the investment performance of real estate private equity.

In the interview, he said: “We have made $184 billion for our investors.” Rightly, he was referring to returns made net-of-fee returns. It is unquestionable that investment returns ought to be judged in a net-of-fee, risk-adjusted light.

Industry advisor Mitchell Bollinger and I analyzed this very issue in “Another Look at Private Real Estate Returns by Strategy,” an article published last fall in the Journal of Portfolio Management. We found that, in the aggregate, non-core private real estate funds – after adjusting for fees and risk – underperformed, or produced negative alpha vis-à-vis the core funds, by approximately 300 basis points annually for the years 2000-2017; value-added funds performed a little worse than this average, while opportunistic funds performed a little better.

These results were robust to various time periods within the sample – including the period before the global financial crisis – so they are not the byproduct of a once-in-a-generation event like the crisis biasing the results. Undeniably, the Covid-19 pandemic is once again raising concerns about the risks previously lying dormant in many private equity real estate portfolios.

Given the size of the non-core market, this underperformance corresponds to approximately $7.5 billion per year in unnecessary investment-management fees, as per our calculations. As such, it is easy to see why some critics of private equity real estate believe that “… we overcharge clients (and) deliver crummy returns…” to quote from Jon Gray’s interview with PERE.

Due to data limitations, our results are aggregated by real estate strategy, therefore, the performance of individual funds or a family of funds, was unobservable to my co-author and me. Moreover, there is significant variation in the cross-section of performance by strategy. Accordingly, it is also possible that Blackstone’s own family of real estate funds indeed generated positive alpha for its investors. To that point, Blackstone’s first quarter filings indicate that its real estate funds have delivered 15 percent net-of-fee returns, since their inception in 1991, to their investors, comfortably within the widely expected return spectrum for opportunistic real estate funds.

In other words, both assertions could simultaneously be true: one, that the real estate private equity industry, in aggregate, has underperformed and, two; that Blackstone, specifically, has outperformed. While I’m confident that the first statement is true, I have no way to tell with regard to the second statement – without applying a version of the paper’s methodology specifically to the Blackstone data. While their cited returns are impressive and possibly suggestive of having produced a positive alpha, they are not definitive without further investigation.

All of which brings me to my larger point. From my perspective, too much of the industry’s discussion surrounding ‘performance’ is done without rigorously considering risk. Performance is often discussed with much enthusiasm, but with little theoretical support; internal rates of return are somehow and suspiciously transformed into ‘alpha’.

While it is easy to correct for fees, it is difficult to correct for risk. These difficulties, however, do not relieve institutional investors of rigorously considering risk. In fact, the Uniform Prudent Investor Act, which sets guidelines for US trustees, states: “The trade-off in all investing between risk and return is identified as the fiduciary’s central consideration.”

To oversimplify, our risk adjustment was to simply lever up core funds in a manner that produced volatility equivalent to that of the non-core funds. What could be more natural to real estate investors than thinking about risk in terms of leverage?

In my opinion, the industry would ultimately be much better served if the underlying real estate performance was unbundled from the effects of leverage.