Alternative asset managers have a rare window into the world of private real estate equity – a perspective that gives them access to transactions which provide an alternative source of returns for investors.

These co-investments are fostered by alternative asset managers’ strong relationships with the commercial real estate industry. After all, lending to the real estate sector is one of the fastest growing segments of Australia’s private debt market and this means managers can also identify opportunities to provide capital to projects in different ways.

Below is an explanation of the commercial property co-investment market – and what it offers to suitable investors.

It is a specialised asset class in which fund managers partner with established property companies to fund the development of commercial real estate assets by either taking equity in projects or providing capital through other hybrid equity instruments.

Typical projects can include:

• Industrial assets such as warehouses and logistics facilities
• Residential developments such as high and medium density apartments, land subdivisions and build to rent projects
• Office developments
• Retail developments
• Health and aged care facilities
• Hotels and accommodation
• Speciality property such as education and recreation facilities.

Commercial real estate co-investment assets can be structured as either:

• Equity or hybrid equity. The latter includes preferred equity instruments which offer the potential for capital growth with greater protection than provided by pure equity.
• Debt investments which benefit from a superior position in the capital structure.

Extensive networks are required to find suitable opportunities as the market has limited participants. Established alternative asset managers often have such networks by virtue of a long-standing track record of providing loans to the commercial property sector.

Commercial real estate assets in Australia and New Zealand offer attractive risk-adjusted returns including the potential for capital gains, but opportunities are very difficult for most investors to access.

Experienced managers overcome these barriers to entry by directly originating opportunities and applying strong risk management frameworks to drive returns and reduce capital volatility.

Commercial real estate in Australia is driven by long-term economic tailwinds, such as strong population growth, housing shortages and rising demand for industrial property due to e-commerce and logistics.

Commercial real estate investment targets opportunities with an attractive risk/return profile, with equity funds generally targeting internal rates of return in excess of 15%. A skilled manager will implement active investment strategies to balance delivery of its target return while also preserving investor capital.

As capital is used to develop property assets, commercial real estate co-investment funds are suited to people with a medium-term investment horizon. 

Other vehicles like Australian real estate investment trusts and unlisted funds tend to invest in completed income-generating assets – they might, for example, own shopping centres or offices. Private equity real estate funds instead finance the development of property assets.

Property development involves different risks than completed assets, which provides the potential for higher returns from co-investment assets of this nature.

Other types of real estate investment funds also offer limited gain outside market fluctuations – if the property market goes up or down, so does the value of a fund’s assets. Private equity real estate can offer potential gains as a result of the skill set required to manage the development of a project.

Some property syndicates take a similar approach, but often invest in just a single asset and have a fixed term with no liquidity windows. Investors’ capital is thus exposed to the success or otherwise of the single asset.

A diversified commercial real estate co-investment fund instead has a portfolio allocated across a range of different project types, in different geographic locations and at different stages of development.

It is important to choose an experienced and well-resourced investment team that understands not just the various sources of income and capital growth available for this asset class, but also the risks associated with it. There are a number of a risks to navigate, including:

• Property market risk: The value of real property assets may fluctuate as a result of a downturn in the relevant market, a downturn in the broader economy or a downturn in a specific segment of a property market.
• Development risk: Property development may be subject to risks which impact timing, cost and successful completion.
• Financing risk: Any breach of debt covenants or other debt undertakings may give rise to certain rights in favour of a financier. Recovery of investor capital may be impacted if this occurs.
• Investment strategy risk: there’s no guarantee a manager’s investment strategy will meet its objectives.
• Liquidity risk: Investments in the asset class are generally less liquid than exchange-traded instruments.