Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

No one knows, of course, what awaits the U.K. in the aftermath of Brexit. But investors and analysts are already anticipating one fallout: a steep drop in U.K. real estate prices.

The fear of a correction in U.K. real estate is wreaking havoc on open-ended U.K. property funds. Investors want out of those funds, but there’s only so much liquidity to go around. For one thing, fund managers can’t just snap their fingers and turn real estate into cash.

More problematically, if property funds sold real estate portfolios at the same time to satisfy redemptions, then property values would tank and investors would be handed deep declines. (This quandary reminds me of an old Steve Martin joke about an investing book called, “How I Turned a Million in Real Estate into Twenty Five Dollars Cash.”)

U.K. property funds caught in a liquidity crunch are doing the only thing they can -- temporarily suspending redemptions -- and seven funds so far have locked up for some period of time since the Brexit vote.

As my Gadfly colleagues Lisa Abramowicz and Rani Molla point out, this isn’t just a problem for U.K. property funds. A growing number of U.S. mutual funds hold private assets, and problems akin to the U.K.'s may be just a panic away.

Which raises a question: Why do investors buy traded funds that hold private assets when they know that they may have difficulty dumping their shares at a reasonable price -- or at all -- when other investors freak out?

One sensible reason is that private assets are a useful way to diversify a portfolio of publicly-traded assets. But there’s another, more dubious reason: Private assets do wonders for the performance numbers of a portfolio.  

The headline numbers for most portfolios are return and standard deviation. The latter metric gauges the volatility -- or bumpiness -- of a portfolio's valuation. The game, of course, is to maximize return and minimize the bumps (or, in other words, to maximize risk-adjusted return, which is often measured by the Sharpe Ratio).

Return for any investment is (mostly) a simple matter of how much I put in and how much I get out, but measuring the bumps along the way for a private investment is not so straightforward. Unlike publicly-traded assets, there are no minute-by-minute market prices to point to for private assets. As a result, the prices of private assets change infrequently if at all, which gives them the look and feel of a stable investment.

Keep It Real
Despite its low historical volatility, private real estate behaved more like a risk asset than a safe haven during the 2008 financial crisis.
SOURCES: NCREIF, NAREIT, Bloomberg

Consider that the NCREIF Fund Index Open-End Diversified Core Equity, which tracks the performance of private core real estate funds, has returned 8.8 percent annually from January 1978 to March 2016 (the longest period for which data is available, and those are total returns), with a standard deviation of 5.4 percent and a Sharpe Ratio of 0.74.

By comparison, the NAREIT Equity REIT Index, which tracks the performance of publicly-traded real estate companies, has returned 12.8 percent annually over the same period, with a standard deviation of 17.3 percent and a Sharpe Ratio of 0.46.

So according to the data, private real estate is only a third as bumpy as publicly-traded REITs, and the risk-adjusted returns from private real estate investments are almost double those from publicly-traded REITs. And the most amazing part of all is that the volatility of private real estate was the same as that of five-year treasuries during the period!

If it all sounds too good to be true, it is. Sure, the magical math of private assets may be fun when it’s smooth sailing, but reality sets in when the storms gather.  

Just look at what happens when things turn south. The downside volatility -- or the degree of bumpiness during periods of decline -- of the NAREIT index was 14.6 percent from January 1978 to March 2016, whereas the downside volatility of the NCREIF index and of five-year treasuries was 8.3 percent and 3.3 percent, respectively, over the same period.

In other words: When it mattered most, private real assets behaved nothing like bonds.

Private Property
The scarcity of real-time pricing data for private real estate contributed to lower volatility and superior risk-adjusted returns versus public REITs from January 1978 to March 2016.
SOURCES: NCREIF, NAREIT
Annualized returns and standard deviations expressed as a percentage; Sharpe Ratio as a ratio.

The 2008 financial crisis is also instructive. The NAREIT index returned a negative 32.8 percent from January 2007 to December 2009. The NCREIF index fared only slightly better, returning a negative 26.7 percent over the same period. And five-year treasuries? They returned 21.5 percent over that period.

Go ahead and flatter your portfolio with eye-popping performance numbers from private assets. But just remember that those numbers are likely to be cold comfort when things get bumpy. If you want to sprinkle these holdings around a portfolio, you'll need to have a long-term outlook and be willing to let your knuckles turn white while you hold on during episodic panics.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in Washington at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Timothy L. O'Brien at tobrien46@bloomberg.net