Co-investment in real estate refers to an arrangement where investors partner with a fund manager or sponsor to invest directly in specific real estate assets, while also investing in the main fund. As a unique investment model, co-investment is gaining popularity among institutional investors looking to boost returns and gain more control over their real estate allocation. This article will explore how co-investment works, its key benefits and risks, and why it is an increasingly attractive option, especially for large investors like pension funds and sovereign wealth funds. By allowing investors to cherry-pick assets alongside fund managers, co-investment provides customized exposure and leverages fund manager expertise, while reducing fees. When executed properly, co-investment can enhance real estate portfolio diversification and returns for investors. However, it also requires strong alignment of interest between investors and managers, as well as greater investment sophistication and due diligence capabilities on the part of investors.
Co-investment enables customized real estate exposure and leverage of fund manager expertise
The core benefit of real estate co-investment is the ability to hand-pick assets alongside fund managers, rather than investing blindly in a commingled fund. This allows investors like pension funds to target assets that best fit their investment criteria and portfolio needs. For example, an investor concerned about inflation may want to co-invest in warehouses tied to e-commerce, which saw strong tenant demand during the pandemic. Investors can also leverage the local market knowledge and deal sourcing capabilities of experienced real estate fund managers to access deals that may otherwise be hard to find independently. Compared to going it alone, co-investing with an existing manager with a solid track record can provide investors with a superior on-the-ground perspective in unfamiliar markets.
Co-investment provides customized real estate exposure with lower fees
Investing directly in assets alongside funds can translate into lower fees for investors, making co-investment an economically attractive proposition. While investors still pay management fees on invested capital to the fund manager, they can avoid extra layers of fees charged on committed capital by commingled funds. According to Preqin research, co-investment management and performance fees were 42% and 63% lower on average than commingled fund fees in 2020. By avoiding excessive fee layers, large investors like pension funds and sovereign wealth funds can retain a bigger share of investment gains under the co-investment model.
Risks such as adverse selection and conflicts of interest need to be managed
While co-investment offers many benefits, potential downsides need to be addressed. A key concern is adverse selection; fund managers may cherry pick the best assets for their main fund, while offloading lower quality assets to co-investors. Clear rules need to govern the allocation process to avoid such conflicts. Investors also take on more responsibility for conducting proper due diligence for each co-investment, compared to relying fully on a fund manager’s capabilities when investing in their commingled vehicle. Lastly, co-investments are generally less diversified and liquid than traditional fund investments, since they involve larger stakes in individual assets that may be hard to exit quickly.
Large investors are increasingly embracing co-investment in real estate
Despite the risks, larger investors like pension plans and sovereign wealth funds are showing growing appetite for co-investing in real estate alongside fund partners. According to Preqin, 97% of investors surveyed expect to maintain or increase their co-investment activity in 2021-2023. The ability to better control their real estate allocation and boost net returns is a major reason driving adoption. As investors grow more sophisticated and build in-house real estate capabilities, co-investment is poised to become an essential component of portfolio construction. Overall, the co-investment route allows large real estate investors to become more nimble and customized in their allocation, while still benefiting from manager expertise.
Co-investment is an innovative real estate investment model allowing customized exposure alongside funds while reducing fees, making it attractive for large investors. Despite risks like adverse selection, strong alignment and governance can help investors manage co-investment accounts successfully.