Commentary: As the real estate cycle matures, hedge fund strategies offer a solution

Institutions, from endowments to pension funds, have good reason to be reassessing their exposure to real estate after a decade of strong returns. Perceived headwinds, including rising interest rates and steep property values, are reducing the appeal of illiquid direct investments and private funds with tight lockups. There is also a growing disconnect between private market and publicly listed real estate investment trusts that are trading well below their net asset value.

While it is still unclear whether these factors reflect a stalled market rather than one that has peaked, we can all agree the final innings of this real estate cycle are upon us. This is the proper point for institutional investors to consider whether to alter or reduce their allocations to the asset class.

As investment teams tackle this dilemma, one solution may exist in an often-overlooked alternative: hedge fund strategies focused on public real estate. Funds investing in publicly traded real estate securities are typically built to capitalize on market dislocations, offer directional flexibility and provide insulation from asset bubbles. In turn, they can be a distinct source of alpha generation and diversification late in a cycle.

This has been the case over the past 12 months based on the HFRX RV: Real Estate index's outperformance of the MSCI US REIT index. Unlike the lead-ups to the 2001 and 2008 downturns, real estate-focused hedge funds have become more adept at sourcing quality long and short opportunities as rates rise and property-linked income levels off.

But perhaps due to the hedge fund industry's headwinds and the limited pool of managers specializing in real estate, comparatively little is known about these specialty strategies. They do, however, represent an attractive late-cycle option.

Unlike private real estate markets, public markets have historically exhibited higher levels of volatility that create significant opportunities to buy and sell securities across a multitrillion-dollar investible universe. This is underscored by the fact that from 2006 to 2009, the MSCI US REIT index swung from trading at a 49% premium to a 48% discount relative to the NCREIF Property index.

Real estate hedge fund managers employing a long/short or relative value approach are best positioned to exploit periodic market dislocations by purchasing high-quality securities at material discounts to private market valuations. Conversely, these managers can strategically use shorts or puts to capture value when mispricing creates a clear opportunity to benefit from pending corrections.

Maintaining flexibility is key to sourcing quality opportunities regardless of the market's direction. But most real estate funds, particularly illiquid ones, naturally struggle during the early stage of a cycle and once a downturn starts. Hedge funds can nimbly buck this convention, though, through distressed asset purchases, opportunistic credit investments and the funding of out-of-court restructurings. Pockets of volatility also represent moments when short positions designed to offset long exposure can generate yield that boosts otherwise negative returns.

When the natural tailwinds of real estate are not manifest within the public markets, managers are also able to generate returns through event-driven strategies and by working with management teams at publicly listed real estate companies to take steps that enhance shareholder value. The unique ability of active managers to function as a catalyst, including through equity activism if they choose, is part of what helps the strategy deliver a diversified stream of returns compared to buy and hold private funds.

For institutions looking at their portfolio's real estate exposure, more of the same is unlikely to be additive. On the other hand, dramatically reducing asset class allocations right now may leave returns on the table. This is why it is an opportune time to evaluate real estate hedge fund strategies that can deliver strong risk-adjusted performance as the cycle matures and resets.

Jeffrey Pierce is managing partner of Snow Park Capital Partners LP in New York. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.