So what is it about residential real estate that's attracting hedge funds, pension funds and other institutional investors? Many of these institutions are looking to hedge their portfolios and increase diversification as they seek yield.
Real estate has become an important part of a diversified portfolio, and these institutions are trying to tap into two significant trends. The first is the widespread housing shortage in North America, and the second is rising interest rates.
Institutions that strike now can lock in low interest rates on their debt before the U.S. Federal Reserve and the Bank of Canada raise rates. However, hedge fund expert Linsey Lebowitz Hughes of Duke University's Department of Economics said the real estate market is already feeling the impact of rising interest rates.
"It’s remarkable how much the real estate market has now softened in the last two weeks, given the rapidly changing interest rate environment," Hughes said in an email. "With the cost of borrowing going up and the anticipation that it will continue to go up, real estate deals are becoming tougher to transact, particularly if there’s any financing involved."
With interest rates starting to rise, institutional investors have already slowed their investments in the space, but many of them already secured billions of dollars in financing months ago — before the initial rate hike. Now they're in the process of deploying those billions in the residential real estate space. Hughes believes hedge funds will continue to make real estate deals as long as they have the cash in hand to support them.
"Given their position in the finance world, hedge funds are often approached to invest in 'off-market' deals," Hughes added. "I believe that this will continue and that these deals can be quite attractive to managers, particularly if they are all-cash and aren’t subject to the increased borrowing costs. However, for folks that are trying to raise capital and market deals and are seeking financing, that environment has become extremely tough in recent weeks, and now the real estate market is starting to feel toppish."
Institutional investors are looking on both sides of the U.S.-Canada border for residential properties to turn into rentals. For example, foreign investors like Canadian pension funds now make up nearly one-third of the institutional investment in single-family homes in the U.S.
In Canada, interest rates are locked in for about 10 years at a far lower rate than where they stand today and where they will probably be a year or two from now. Additionally, hedge funds and other institutional investors have the advantage over individual homebuyers. They can secure lower interest rates and probably have a team in place to complete renovations quickly, increasing the value of their properties and the returns on their portfolios.
Success for smaller institutions
Canadian family offices and smaller investment funds are looking to tap the same market that hedge funds have been circling for years. However, one of the biggest barriers to success in this type of investment is finding the expertise needed to manage a real estate portfolio dispersed across a large geographic area.
According to Sabine Ghali at Buttonwood Property Management, succeeding in the hold phase of an investment requires institutions to know the Landlord and Tenant Board's rules and be familiar with the human rights tribunal.
Ghali said institutional investors must be able to do both small and large renovations. More importantly, she said it's important for them to be ethical in all their dealings.
"A reputable property management company with a track record of success is an important aspect of this puzzle to make the investment a profitable one," she said in an email. "The hold phase of the investment is the hardest one. Investors buy for one reason, but they sell for many reasons. A property management company can mitigate a lot of those reasons."
Location, location, location
Hedge funds that find success in owning single-family homes and other residential properties understand the variables associated with every investment. For example, they understand that the more desirable the country and city are, the lower the returns. However, there's much more than meets the eye to this observation.
Returns on properties in Arizona have been much higher than returns on Toronto properties over the last 20 years, but that doesn't take into account capital appreciation. Property prices in Toronto have been skyrocketing over the last two decades.
Other issues are also affecting the real estate market in this post-pandemic world. Many people are moving to warmer locations like Florida and Texas, which also offer lower tax rates. As a result, the pent-up demand in some areas has created hot areas, so the institutions that find the most success are those that know where to buy properties.
Final thoughts
Real estate has typically been an excellent long-term investment, particularly during periods of market turmoil. Hedge funds have understood this well, jumping into the space to balance their equity investments with some brick-and-mortar rental properties to weather the next market downturn.
Hedge funds with plenty of cash can take advantage of the widespread housing shortage, leaving smaller investors that rely on financing behind
"All-cash deals are easier to move forward [right now], but the increase in financing costs can quickly eat into profits, diminishing their appeal," Hughes emphasized. "This current storm is going to affect all investors, including hedge fund managers."
*Courtesy of Forbes