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Closed-end real estate funds and open-end real estate funds may employ different strategies, but their aggregate performance in the U.S. has been surprisingly similar in recent years. While there are differences that underlie this performance, investors need to be mindful that their outcomes are unlikely to be average. The timing of cash flows into and out of funds can have a significant impact on performance, and fund selection matters.
Surprisingly Similar Returns
One way for investors to access private real estate is through pooled unlisted funds. These funds can be either open-end or closed-end. Despite their differences, analysis shows that the performance between these fund groups has been remarkably similar at the aggregate level. This suggests that they may have more in common than some investors assume and highlights the importance of the underlying drivers of performance in the real estate market.
The exhibit below compares the performance of open-end funds and closed-end funds in the U.S. The trends in rolling 12-month time-weighted total returns have been remarkably similar, although some differentiation exists. The annualized time-weighted total return for closed-end funds was 3.2% compared to 4.0% for open-end funds.
Similarity in aggregate performance, however, masks a significant difference in the dispersion of individual fund returns between open-end and closed-end funds. Closed-end funds had a wider range of returns, indicating that fund selection plays a crucial role.
Investment Timing Was Key for Closed-End Funds
Investment timing dynamics have a significant impact on the performance of closed-end funds. As managers draw down capital and return it to investors, the proportion of committed capital employed varies throughout the life of the fund. On the other hand, open-end funds face pressure to quickly invest capital and return it to investors. These differences in timing have traditionally led to different measurements of performance for open-end and closed-end funds.
Measuring the money-weighted returns of closed-end funds using the internal rate of return (IRR) reveals a premium over the time-weighted returns. In the case of the analyzed closed-end funds, the money-weighted returns were 5.25%, a 2 percentage point premium over the time-weighted returns of 3.2%. This indicates that investment timing had a positive impact on the performance of closed-end funds.
Achieving Market Returns Through Closed-End Funds Took Strong 'Commitment'
Individual closed-end real estate funds can have a wide range of performance outcomes. For example, looking at the 504 U.S. closed-end real estate funds with vintages between 2008 and 2020, the aggregate-level since-inception pooled IRR was 11.27%. However, the 95th percentile had a return of 24.2% while the 5th percentile had a return of -19.0%.
To understand how diversification affects closed-end real estate portfolios, a Monte Carlo simulation was conducted using data from the same 504 closed-end funds. The simulation showed that portfolios with more commitments per year had a narrower range of expected returns. However, even with a large number of commitments, investors may still face a wide range of potential returns. This underscores the importance of fund selection in influencing portfolio performance.
It's All in the Execution
The similar aggregate-performance trends between closed-end and open-end funds in recent years highlight the commonality of underlying return drivers. However, this should not lead to the conclusion that the allocation decision between these fund types doesn't matter. Based on the analysis, individual commitment selection and timing have proven to be crucial variables for investors using closed-end funds to construct real estate portfolios. Even large closed-end portfolios can have significantly different performance outcomes from the market aggregates used in strategic allocation decisions.
Investors should remain aware of the unique dynamics and considerations when investing in closed-end real estate funds. Fund selection and timing can make a significant difference in achieving desired outcomes.
References:
- Benchmarking in Private Real Estate: Beyond Performance Measurement
- Real Estate Asset Selection Mattered — Especially in a Crisis
- Apples vs. Oranges? Core vs. Opportunistic Real Estate Funds
- Digging deeper into pan-European property funds’ performance
- The Right Tool: How Suitable is Your Real Estate Benchmark?
