Family offices double down on real estate

Despite uncertainty hanging over real estate, the asset class continues to feature prominently in portfolios of wealthy families, with sustainability becoming an added attraction.

With its attractive mix of stable income, long-term capital appreciation and diversification against market volatility, real estate has historically represented a large allocation for wealthy investors. Ultra-high net worth families feel comfortable with this tangible, ‘bricks and mortar’ asset, well suited to their multi-generational investment horizons.

While many invest in funds for diversification purposes, direct ownership of properties remains the most popular way for the wealthy to invest, as it allows them full control over management and leverage.

“Family offices (FOs) have access to patient capital and tend to bring in entrepreneurial spirit to investing. As such, they have a fairly high allocation to alternatives, including real estate,” says Maximilian Kunkel, CIO, global family and institutional wealth, UBS Global Wealth Management.

Within a typical allocation of 40 per cent or more to alternatives, real estate represents 10 per cent of portfolios, he says, referencing the global bank’s latest study on family offices.

“Family offices like real estate for its yield and perceived price stability in inflation-adjusted terms, especially given absence of frequent mark-to-market swings and because of its long-term uptrend,” explains Mr Kunkel.

There is also an “emotional value” associated with real estate, especially relating to prime location properties. “A real asset, which you can touch and feel, has a very different value within the context of a portfolio; it is not just an asset with an ISIN number attached to it,” he says.

But with the malaise that hangs over the real estate market today, will the asset class continue to appeal to wealthy investors and their family offices?

Sold out

The Fed’s period of rapid interest rate hiking during 2022-2023, to tame persistently high inflation, is judged to have badly hit the real estate market, which is highly dependent on leverage.

As a result, there has been a “material drop” in allocation to real estate in FO portfolios, from 14 to 10 per cent between 2019 and 2023, according to UBS.

“It is not that FOs have significantly sold out of real estate, but they've put less of the marginal dollar into real estate and more into other alternatives – especially more liquid alternatives – providing stability and yield, such as fixed income,” explains Mr Kunkel.

As the rate cutting cycle in the developed world begins to take effect, the trend is likely to move in the other direction, with FOs expecting to increase allocation by a couple of percentage points during 2024, according to the bank’s study.

FOs are also increasingly opting for funds which diversify real estate portfolios geographically, against a backdrop of increased geopolitical risk (see chart). When owning it directly, wealthy families traditionally focus on local real estate, because of their perceived better understanding of local market dynamics, as well as access to opportunities and capital through established sources of funding, adds Mr Kunkel.

While the fastest rise of interest rates since the 1980s has proved a major headwind against real estate, significantly driving down supply, it has not had a major impact on families’ allocation trends, according to JP Morgan Private Bank. Today, 77 per cent of JP Morgan’s FO clients have an allocation to real estate, accounting for 14 per cent of portfolios on average.

“I tend to think of our community globally as a strategic asset allocator, where wealthiest families can lock away their money for a very long period,” says Thomas Kennedy, the bank’s chief investment strategist.

While real estate allocations have changed little, there is a clear shift in types of assets owned. “Rotating away from areas like offices and into data centres has been the trade so far this year,” says Mr Kennedy. Most of clients’ real estate investments are through funds. Reits (real estate investment trusts), which can be bought and sold like stocks, are also popular.

Rising data centres

Some funds selected for clients allocate more than 20 per cent to data centres, versus 8 per cent for the listed market. These physical facilities storing digital data and computing infrastructure are developed for the economy of tomorrow, with AI poised to drive a 160 per cent increase in data centre power demand by 2030, according to Goldman Sachs.

Rising prices are driven by big demand supply imbalance. While it takes three to five years to build a data centre, most data centres in production are already pre-leased, according to CBRE.

“The biggest risk for data centres is that AI is a fad and will not add productivity to the economy,” says Mr Kennedy. Also, the ability for AI to work relies on “a massive infrastructure bill, both in the US and across the world”, which may not materialise.

Data centres, and industrial real estate in general, including industrial and logistics buildings for online shopping, represent the biggest allocation in real estate investments, together with residential and retail, because of consistent income and price appreciation, he says.

Trends for residential, especially multi-family, buildings are driven by demographic and macro-dynamics, with the highest immigration flows in the US since the early 1990s fuelling new home demand

While retail has “held up well”, despite the rise of e-commerce, demand for office space is “crashing” because of increased work from home activity since the Covid-19 pandemic.

In this environment, diversification is crucial.

“Never in history have you seen dispersion like this in valuation of different parts of real estate,” says Mr Kennedy. “From the global financial crisis to Covid, with ultra-low interest rates, all assets would go up and investors could buy a buy a real estate fund and don't worry about it. Now, as winners get separated from losers, you do need to be selective.”

Lending against real estate is also a boon for the rich. “Real estate is an asset clients can wedge as collateral, consistently through time. While it is not the primary rationale for why the wealthy are buying real estate, it is certainly part of the combo,” he says. Banks’ lending activity – closed for two years – is now slowly reopening as rates have come down.

Entry route

A key reason why private capital and wealthy individuals favour real estate investment is because through management they can affect performance, says Liam Bailey, head of global research at Knight Frank, the London-headquartered global real estate consultancy and estate agency.

For many families “an entry route into direct property ownership” is acquisition of the building to host their family office, where extra space is rented out. But to achieve diversification through direct ownership, families need “deep pockets”, as real estate is relatively illiquid compared to other financial assets and involves huge investment, he says.

“Investors are looking for opportunities everywhere. But there is still probably a bias towards bigger, more liquid markets, such as London or Manhattan. Investors pay a premium for entering but liquidity is high, which means investors can time their exit relatively well.”

Cash is king

While data centres are today’s most popular assets, there is a limited stock of properties that can host them, for which there is rent premium. As a result, investors end up gaining exposure to traditional sectors, including the office market, says Mr Bailey.

Contrary to the 1980s and 1990s’ trend towards business parks in suburban areas, the rise of hybrid working post-Covid has accelerated companies’ demand for high quality buildings in cities’ central business districts. Demand for secondary offices has dramatically fallen.

“Companies want to occupy buildings that encourage workers to come into the office and attract new talent,” so offices need to be in the centre of big world cities, where they can have networking spaces or events, says Mr Bailey. “The competition for best-in-class offices has never been higher. Rents have risen as a result.”

Distressed commercial real estate, and offices in particular, may represent interesting opportunities to wealthy families, with strong cash reserves, says Steven Saltzstein, CEO, Force Family Office, the largest US family office network. “In difficult times, in areas like commercial real estate, cash is king and wealthy families can swoop up and grab bargains, which other folks don’t have means to buy.”

“The challenge is to turn commercial buildings into residential,” he says. “Floor plates are not conducive to that, and often it is better to tear buildings down and rebuild them.”

Tax advantages

Many families are putting allocations “on pause”, awaiting more certainty in the environment, notes Paul Karger, co-founder and managing partner at US-based multi-family office TwinFocus Capital Partners.

“With real estate, as with private equity, you make all your money on the buy,” he says. “If you buy something too expensive, you've got to hope and pray it's going to get more expensive, so it's better to buy something cheap.”

“The real estate market is frozen right now,” he says. Negative leverage is hurting returns, which is paralysing asset managers’ activity. Right now, “the whole real estate world is hinged on lower rates, and hoping and praying rates go down”.

Yet, real estate makes “a lot of sense” for wealthy families. “We love real estate, especially for US taxable investors. There's a lot of tax advantages for families owning real estate,” says Mr Karger.

The ultra-prime, ultra-luxury segment of the market was left relatively unscathed from the rapid interest rate hikes of the past two years, states Georgina Atkinson, managing partner of Dubai-headquartered advisory firm, Origin. “Our clients don't leverage, so they're not impacted by interest rates. In New York, 80 per cent of our buyers are cash buyers,” explains Ms Atkinson.

Ultra-wealthy families focus on markets around the world – offering capital preservation for future generations – including London, New York, Los Angeles and Miami, she says. Families buy to rent, or buy as a second home, or they may purchase properties for children studying abroad, with a specific “checklist in terms of requirements”, including safety, security, access, as well as education, green space and facilities.

A key trend she sees is a “huge increase in female investors wanting to invest into prime real estate around the world, to diversify their portfolio and protect their wealth”. This is a break from the past when real estate was male-dominated.

Building back greener

Wellness and sustainability have become “huge themes” for developers and clients. More and more features are being incorporated into new developments around the world, including health clubs and six-star medical facilities. “Health and wellness have played a huge part in new developments, particularly since the pandemic, and will continue to do so,” explains Ms Atkinson. These types of developments, promoting “a holistic and balanced lifestyle”, command a price premium, which clients are willing to pay.

Real estate can make significant contribution towards decarbonisation and provide attractive returns too. The ‘green premium’ is prominent in offices and industrials. Thirty-six per cent of Europe's greenhouse gasses come from the built environment, according to Fidelity International.

While the US regulatory push is less obvious, in Europe the trend towards green buildings is driven by policy and planning, both at EU level with the European Green Deal, and at individual government level.

Another structural driver is increased demand for operationally net zero carbon buildings, to meet companies’ ambitious net zero carbon goals, explains Kim Politzer, director of research, European real estate, Fidelity International. Almost 40 per cent of firms have set a 2030 goal for net zero carbon, according to CBRE, but only 1 per cent of building stock is being refurbished or redeveloped every year.

The “significant shortfall in the run up to 2030 in buildings that meet occupiers’ requirements” means supply/demand imbalance is set to produce “very attractive returns, and a significant green premium”, says Ms Politzer.

Demand for buildings meeting “highest green standards” also from increased focus on sustainable investment returns.

“Now is a very attractive point to be entering the market and acquiring buildings for this ‘brown to green’ transition, particularly given we have seen about a 25 per cent hit on property values over the last two years because of interest rate increases,” she says.

“Sustainability is top of mind for families,” states Force Family Office’s Mr Saltzstein. “They want to make sure their real estate investment is sustainable, good for the environment and society, and they can pass it on to the next generation, as something to be proud of.”