Why institutional investors need to invest in residential real estate

Rayan Rafay, CFA – Managing Director, Head of Portfolio Management

With over $71 trillion USD in assets under management^[1], institutional investment is a core driver of the global economy. Institutional entities have the common objective of generating cash flows capable of fulfilling future obligations. These obligations fluctuate with respect to economic factors such as interest rates, inflation, and unemployment rates. In addition, the compounding nature of investment returns means that significantly more capital is required to fulfill a short-term obligation in comparison to a longer term one.

The three most common types of institutional entities are pensions, endowments, and sovereign wealth funds. Pensions serve a fundamental societal need. Funds are invested during the service period of an employee, which are later drawn upon to support an employee’s needs after retirement. Endowments, on the other hand, invest money today in order to support the future of organizations and institutions. These entities are often faced with recurring annual expenses, and will, therefore, benefit from investments that provide cash flows to match these needs. Finally, sovereign wealth funds use government surpluses to invest in a variety of assets to diversify a country’s economy or to be drawn upon in times of economic distress.

Institutional investment strategy is determined largely by the interest rate environment. In a high rate environment, fewer risky investments are required because lower risk investments provide adequate returns. However, when interest rates are low, such as in our current environment, many of these institutions find themselves underfunded and needing to take on more risk or require additional funding in order to meet obligations.

Based on the Willis Towers Watson Pension Index, the average US plan has only 73% of the assets needed to fund their respective liabilities. In an extreme case, the city of Detroit marked US history as being the first municipality to declare bankruptcy, an event largely driven by the degree to which its pension funds were underfunded (having fewer assets than needed to meet liabilities).

Inflation is the second principal driver of institutional investor activity. Inflation often determines the amount of payment that must be made to an employee in retirement or by an endowment to the institution/organization it is supporting. This is usually detailed in the contract given the significant impact inflation has on the purchasing power of a retiree or the changes in costs facing a funded organization.

Over 40% of inflation is determined by the cost of housing; it is the largest component of inflation (CPI) in the United States and for most of the world. Historically, the only way to hedge inflation was to purchase TIPS (treasury inflation-protected securities), which are scarce and oddly constructed, or to purchase some proxy for inflation, be it commodities, farmland, or infrastructure. Investments in these assets are predicated on their historical link with inflation, rather than them being a material component of CPI. The cost of housing, however, is a direct component of inflation and is a much simpler, purer way to hedge the inflation exposure that is innate in institutional investors’ liabilities.

Investing in housing has historically been problematic, as the only way to access the asset class has been through mortgages or the purchase and subsequent rental of homes. Mortgages are a fixed income investment with no value participation, and purchasing homes as rental properties are difficult to scale and are expensive as a result. Ultimately, a mortgage is more sensitive to the credit risk of the homeowners and interest rates than any other factor. While mortgages and rental properties at various times in the market cycle can be an attractive total-return investment, neither can deliver the investment attributes for hedging or outperforming long-dated inflation that is the core investment objective that a liability-focused institutional investor seeks to fulfill.

US Single-Family housing constitutes $30tn in total value^[2] making it the largest asset class in the United States. With approximately $162tn in total value globally, it is also the largest asset class in the world. For any large institutional investor, making investments in all investable asset classes is important to consistently achieve strong returns with a prudent level of risk.

These two motivations – inflation hedging and exposure to the largest asset class in the world – make single-family real estate very compelling to an institutional investor. Home equity investing, alongside a homebuyer or through purchasing a piece of equity from an existing homeowner, is a frictionless way to invest and not have to worry about the maintenance of the property, tenants, or vacancies. The typical setup of a single-family home equity fund (10 – 50 years) is also attractive to institutional investors who worry about inflation in the long-term but are rarely concerned about inflation in the short-term. Finding investments that will keep up with inflation over the long-term is challenging.

For these reasons, institutional investors are supportive of establishing residential equity as a widely-accepted and invested asset class. On the receiving end, this need for institutional investors to gain exposure to single-family housing provides homebuyers and homeowners with a way to access housing, lower monthly payments, or remain in their current home in a way that was previously not possible. For savvy homeowners it also allows them to disentangle their property investment with the emotional concept of a ‘home.’ Having too much of your net worth tied in one property is a very risky investment strategy. Often, young homeowners will own a home worth many times their savings. The ability to diversify one’s assets away from a single, large investment, while still retaining one’s home, is a socially beneficial function.

Unison endeavors to bridge the gap between these fundamental needs by providing institutional investors the opportunity to invest in single-family housing and offering homebuyers and homeowners access to alternative non-debt capital. Consumers interested in working with Unison should visit Unison

[1]Global Asset Management 2016: BCG

[2]Zillow Research. How Much is Every Home in America Worth? A lot. Svenja Gudell, December 31, 2016