May 10, 2022

Thematic, Passive, Index-Type Investing Comes to Real Estate

Thematic investing is an approach that focuses on predicted long-term trends and macroeconomic impacts. This is a fancy way of saying investors buy into a particular industry or niche instead of one stock. Due to the success of exchange traded funds (ETFs) like SPDR, thematic investing has never been more popular. There are now more than 6,000 ETFs listed, and the list continues to grow. Investors want to allocate capital to specific ideas and themes, not companies. These themes can revolve around a sector, size, geography, or any other factor and thematic investing offers an entirely different level of control.

Despite this control, ETFs are a passive strategy because investors don't actively choose the stocks. Active managers of mutual and hedge funds argue that their holdings will outperform a benchmark index based on expertise, but the numbers say otherwise. Since the beginning of 2009, the S&P 500 has outperformed Hedge Funds by an average of [8.5%] a year.

This isn't a new debate. In 1972 Princeton University’s Burton Malkiel published “A Random Walk Down Wall Street”, which arguably inspired the first passive index fund from Vanguard in 1976.  Since the 1970s, passive management products have been mirroring a benchmark index, often at a lower cost. It is no surprise that investors are attracted to lower fees, better diversification, and higher returns. According to Morningstar, actively managed funds have repeatedly failed to beat their benchmarks. In fact, only 23% of all active funds topped the average of their passive rivals over the 10-year period ended December 2020. Over the past decade, more than three trillion dollars have flowed to passive equity investing strategies. Morningstar states that passive funds now hold more than 50% of investment assets.

Passive Investing has proven to be the winner in the equities space.

But what about real estate?

Real estate investors have yet to adopt passive strategies. This isn't because there isn't an appetite for an index-style product, it is because the product didn't exist.  Active real estate managers will give the same reasons to justify high fees that hedge fund managers gave, and the numbers still don't add up. In the last 10 years Blackrock, Invesco, Morgan Stanley, and others have made millions in real estate management fees. Yet, when we compare their results (NCREIF Property Index) to the standard Commercial Property Returns Index (CPRI), the results are virtually identical. This begs the question, what did they do to earn those high fees?

What does this all mean and where does it lead?

We think that the migration from actively managed strategies to passive strategies that has already occurred in ALL other asset classes (equities, fixed income, commodities, listed real estate) will also occur in private real estate.

Why this good for investors:

  1. Fees will come down.
  2. Net returns will go up
  3. More liquidity
  4. More transparency

The Index Style City Fund

A Cityfund is an index-like investment product for a city’s residential real estate market. Each Cityfund is intended to hold investments in a diversified portfolio of single-family residential properties in one city, and one city only. The Cityfund is based on the transformation we have seen in the equities market from actively managed mutual funds to passively managed ETFs. We believe that this migration in investment strategy will soon take hold in the real estate space and wanted to create real estate investment products which offer the same advantages as ETFs in the equities space.

The low fees of ETFs are one of the major reasons why capital has migrated away from high-load mutual funds. We are starting to see this trend in the real estate space (and it’s why some of the larger private equity funds are now looking towards retail investment products). We believe that the majority of the returns generated from stabilized real estate is derived from the underlying market’s performance and not from the investor’s ability to source and select individual assets. This being the case, we believe that investors are heavily overpaying for actively managed real estate investment selection. As an index-like product, investors receive 100% of the net returns of the Cityfund portfolio - no promotes, no carried interest.

The Real Estate investors market is long overdue for a thematic investing approach. The future options are wide open. Niche markets that are possible targets for this type of investing would include multifamily homes, condominiums, homes in retirement communities, Hawaiian Homelands, tiny homes, and many more. The Cityfund is active now and we hope this is the first of many thematic real estate investment opportunities.

Written by

Sundance Brennan & Jesse Stein