Revealing the real case for real estate

The reasons given for investing in private real estate typically include diversification benefits and illiquidity premia. However, the real case for real estate should be based on how the inefficient nature of the asset class creates potential for significant alpha generation.

Today, private markets are distinctly less efficient than public markets. One hundred years ago the distinction was far less pronounced. Then, both public and private markets looked fairly inefficient. All market participants would have exposure to very different information sets – in part because information travelled far more slowly than it does today.

But a key difference emerged after the great depression as regulations were introduced to improve the fairness of exchange-traded stocks and bonds. Regulatory change since has generally worked to further restrict scope for traders to be advantaged by inside information, particularly post-Enron.

All information relevant to the price of publicly traded assets should be in the public domain today. Public markets have become progressively more and more efficient.

And there is reason to believe that a higher percentage of market participants are digesting the full information set available. The composition of who is participating in, for example, the stock market has changed very meaningfully over the last half a century.

Individuals used to be significant market actors. In other words, there were some amateur investors in the market to take advantage of.

But now the stock market is fully professionalised and financial institutions dominate - all with access to very similar technologies and comparable analytical capabilities.

So generating alpha in public markets has become increasingly difficult. It is very hard to have an information advantage, or an analytical edge. Public markets are now a level playing field. The dispersion of returns for active managers has become very narrow.

In contrast, private markets remain inefficient and continue to lack transparency.

To those more familiar with public markets, such characteristics can be off-putting or interpreted as a lack of market maturity.

But the lack of transparency and associated inefficiency is an inherent and inevitable feature of real estate. Properties are highly heterogenous. One asset is unlikely to be directly comparable to another. And so the cost of gathering information is high. Consequently, it is possible – and legal – to have a significant information advantage over others in the market.

Real estate investors should therefore position themselves to develop and exploit information advantages. They can do this, for example, by focusing on specific locations or niches and becoming deeply embedded in a certain market. Focused investors can better spot attractive entry points and more successfully add value.

The inefficiency of real estate should therefore be embraced and celebrated.

The wide dispersion of returns for active managers demonstrates that greater opportunities exist for alpha generation in private markets. But selecting the right manager or strategy is critical.

Where active managers have positioned themselves to have an information advantage, exploit complexity and find easy games, the real case for real estate is compelling.