Over the last two years, capital markets have faced some of their biggest headwinds in decades due to the Federal Reserve’s continued efforts to restrain inflation through higher interest rates. Today’s economic backdrop has the U.S. moving from a low-inflation environment to one with higher nominal GDP growth and more inflation in the system.
Strategic Portfolio Allocation in a Changing Environment
Given this new macroeconomic backdrop, the question arises: How should investors adjust their portfolios? One prudent move is to increase allocations in collateral-based cash flows backed by hard assets, namely, real estate. More specifically, increasing exposure to debt-focused private REITs is a benefit to all portfolios at this time. In this article, “private REITs” refers specifically to an SEC-exempt vehicle that requires larger minimums and is only accessible to accredited investors and qualified purchasers. It is not referring to non-traded REITs, which usually need to be SEC-registered and allow for retail investor allocations. This asset class offers a compelling risk-adjusted yield that can serve as a stabilizing income source in a diversified portfolio.
From a financial advisor’s perspective, the inclusion of private REITs in client portfolios offers multiple advantages. Historically, real estate has been a reliable hedge against inflation, but the focus has often been on equity-based investments. For roughly 14 years prior to the U.S. Federal Reserve’s rate hikes in March 2022, we found ourselves in a lower interest rate environment where the theme was high growth, long-duration investment-grade debt and asset allocation. Today, the playbook is different, and shifting to short duration debt and consistent yield with a healthy risk premium. Debt-focused real estate investments in this environment can provide clients with steady income streams that are less volatile than traditional equities and more resilient than fixed-income products.
Income Stability and Risk Management
One of the most significant advantages of debt-focused private REITs is the ability to generate stable, inflation-linked income. For clients with financial obligations or approaching retirement, this income stability is crucial. Unlike equity positions, which can be more susceptible to market fluctuations, debt positions—especially those in senior tranches—offer a layer of security and predictability. This security is particularly valuable in today’s uncertain economic times, where traditional fixed-income products are no longer the safe havens they once were.
By investing in senior positions in the capital stack, these REITs ensure that investors are repaid sooner than other capital participants, thereby reducing the risk of capital loss. Advisors should note that this conservative approach can be especially appealing to their clients who are risk-averse but still seek reasonable returns in a challenging economic environment.
Tax Efficiency and Diversification
Tax efficiency is another key consideration. Private REITs can offer substantial benefits, including the ability to structure investments in ways that reduce tax liabilities for investors. For instance, the offshore LP structures available in some private REITs can help clients reduce their tax burden significantly as they offer investors a 20% tax deduction on the income they generate, thus enhancing after-tax returns.
Moreover, private debt REITs provide a unique opportunity for portfolio diversification. Traditional portfolios heavily weighted in stocks and bonds may not offer the same risk-return profile in a high-inflation environment. By diversifying into real estate debt, advisors can help clients achieve a more balanced portfolio, one that is better equipped to withstand economic volatility. This is particularly true in sectors that have shown resilience, such as multifamily housing and industrial warehouses, where demand continues to outpace supply.
Adapting to the ‘Higher for Longer’ Rate Environment
The Federal Reserve has paused interest rate hikes, and the futures market, as of the time this article was written, anticipates a modest decrease in rates in late 2024. That said, many experts believe that markets will deal with a ‘higher for longer’ rate environment, which presents both challenges and opportunities. In this scenario, there is the ability to earn equity-like returns with bond-like risks through real estate debt investments, without the same duration risk as traditional fixed-income products.
Financial advisors should recognize the strategic role that private debt REITs can play in this environment. By staying patient, disciplined, and forward-looking, private lenders are positioned to be major players in the sources of mortgage capital, offering attractive yields with lower volatility. For clients seeking both income and capital preservation, these REITs provide an essential component of a well-rounded investment strategy.
Conclusion
In conclusion, private debt REITs offer a unique blend of income stability, risk management, tax efficiency, and diversification. As the economic environment continues to evolve, financial advisors should consider these investments as part of a broader strategy to help clients navigate uncertainty while still achieving their long-term financial goals. By adapting to the changing landscape and incorporating real estate debt into client portfolios, advisors can offer a prudent, forward-looking solution that meets the challenges of today’s markets.
Drew Weinstein is Vice President, Investor Relations at Parkview Financial
