The Dynamic Evolution of Private Market Real Estate Investing

[The private markets investment landscape today provides an excellent example of how the asset management industry has been in continuous evolution to meet client needs and offer access to new investment opportunities. Once only the realm of institutional investors, structural shifts underway in the private markets arena from the traditional closed-end, drawdown limited partnership structure to semi-liquid, evergreen products are changing the way fund managers operate in that restricted investment space. This is providing a double win – a more efficient investment and funding process for private markets managers while opening up a larger universe of investors to participate in a wider range of investments for portfolio diversification and risk management.

This rapidly emerging evolution opens up substantial opportunities for financial advisors and their clients per the statistics reported by Pitchbook’s research on The Evergreen Evolution. With $450 trillion dollars globally under advisor wealth management that has historically been given limited access and Reg D restrictions to private markets, the result has been an estimated $15 trillion invested in private market drawdown funds clearly demonstrating that investment portfolios have been severely under-allocated to this key private market asset class. Pitchbook projects if 5% more of that global wealth were to be allocated to private markets, that would be more than $22 trillion in total new capital flowing from the wealth channel over the coming decade.

To better understand the changing nature of the private markets, we were introduced to Mark Tecotzky, Vice Chairman & Head of Credit Strategies, and Greg Valli, Portfolio Manager, at Ellington Management Group – an institutional private credit debt management firm with a diverse structured credit platform across the liquidity spectrum. They are making their institutional strategy available through an evergreen fund structure with the upcoming launch of their non-traded real estate investment trust (REIT), Ellington Real Estate Income Trust (EREIT), which is focused primarily on residential mortgage debt. We asked them questions to learn from their unique perspectives as leaders in the institutional private debt markets and their thoughts on bringing these investment opportunities to financial wealth advisors and a wider audience of investors.]

Hortz: Can you provide us with a little background on your firm and how you developed your investment expertise in the private credit markets?

Tecotzky: Since the firm’s founding in 1994, we have been focused on opportunities in mortgage-backed securities (MBS) and have been building the firm brick by brick, gradually expanding the sectors that we invest in. Initially we were primarily focused on Freddie Mac and Ginnie Mae MBS, but we expanded into non-agency Residential Mortgage-Backed Securities (RMBS) through the 2008 crisis to take advantage of the distress in subprime and option adjustable-rate mortgages (ARMs).

Now we are involved in a number of different sectors, such as non-qualified mortgages (non-QMs), which have been around for 10 years as a result of stricter post-GFC (Great Financial Crisis) agency underwriting standards. An area of particular interest right now are second liens and home equity lines of credit (HELOCs), which are growing because you have so many borrowers with great credit and low loan-to-value (LTV) ratios that want to tap some of their home equity but are locked into very low, fixed rate first mortgages.

So that’s how we got into private credit – we did not start the firm thinking we wanted to be a private credit firm – we started the firm saying, “if you are really good at housing analytics, you can generate above-market returns over cycles, over time.” The opportunity set in mortgages now is just such a high yielding opportunity set that it is consistent with the expected returns in private credit.

Valli: This area of the mortgage marketplace works differently to what some of the big private credit platforms currently do. These managers typically invest in large corporate loans where the analysis is more about a bottoms-up corporate balance sheet analysis. We, on the other hand, are studying individual mortgage loans which lends itself to statistical analysis.

We are known for our proprietary statistical models, and 25% of our over 150-person firm is in systems, risk, and research. We have committed to a big data spend and buy a lot of data – and build our own models that are calibrated to that data – which has led us to consistently strong risk-adjusted returns. So, it’s just a constant ongoing process of acquiring new data, building more thoughtful models, and giving ourselves better analytic tools to understand mortgage credit and prepayment risks.

And our process is never over as there is constant innovation happening in the mortgage market – there is always new data, and we are continually trying to absorb and feed that into models to get the best risk adjusted returns.

Hortz: What are some of the challenges of being an investment manager working in the traditional private market structure?

Valli: One of the biggest challenges for the investment manager in a traditional closed-end drawdown private market LP structure is that when you have capital commitments, you want to get it invested quickly, but the market opportunities are not the same every day. It is a question of being patient, balancing wanting to get invested and wanting to maximize returns.

The challenge is trying to time the best opportunities and be ready if the market hits an air pocket where you can find outsized returns or can lean into a technical dislocation – so it could take some time to get fully invested. I think it just comes down to manager skill, and we believe that we have handled this challenge. If you look at the bios of our investment team, you will see a tremendous amount of experience. Our senior portfolio managers have an average of nearly 30 years each in these markets.

Hortz: How did you navigate your decision to shift to a non-traded REIT vehicle?

Tecotzky: We wanted a vehicle that could be exclusively focused on residential housing credit that was going to appeal to retail clients who did not want a lot of volatility and offered some tax advantages and liquidity options. The non-traded REIT structure gave us those variables.

On top of that, we thought that the market lacked an offering focused on residential mortgage debt like we have here. There are real estate offerings where you are exposed to real estate equity and commercial mortgages, but none are all-in on residential housing-related debt offerings. We did not see any other vehicle with the same investor parameters, structure, and benefits out there that would be a competitor. We feel we are breaking fresh ground with our non-traded REIT.

Hortz: How exactly does a non-traded REIT structure provide you with more investment flexibility and support your investment process?

Valli: The added investment flexibility comes from the fact that the vehicle attracts long-dated capital that allows us to not worry about short-term mark-to-market volatility while providing us with the opportunity to take advantage of mortgage market dislocations and really think about returns on invested capital over a reasonable two to three year holding period.

Many times, the best opportunities come in markets that have some choppiness, like in 2022 when there was a huge amount of selling from fixed income money managers that were managing daily liquid 40 Act funds and faced redemptions when rates were going up. The non-traded REIT structure allows managers to capture some of the best opportunities in this credit marketplace.

The other thing about long-dated capital is that we have the time to buy loans, securitize them, and then retain the highest yielding portion of the securitization, which is not the kind of investment process you can access in a public mutual fund. The non-traded REIT structure allows us to elegantly capture the best opportunity sets we see in the residential mortgage space but sidestep some of the liquidity or NAV volatility concerns that you see in other vehicles.

Hortz: How does this shift to a non-traded REIT vehicle provide benefits for investors over the traditional private market drawdown structure?

Tecotzky: The non-traded REIT structure provides a simpler, more efficient investment offering versus the traditional private credit drawdown/finite life structure: more dynamic liquidity features; lower volatility than an exchange traded vehicle; tax-friendly REIT structure and 1099 reporting; ability to buy-in at NAV; a seasoned portfolio of diversified assets versus a rushed deployment of capital calls; gaining more exposure to the benefits of compounding; and no arbitrarily mandated, finite-life, 10-12 year investment liquidation timeframe.

The non-traded REIT structure also provides benefits for investment managers by providing an easier-to-manage investment vehicle and perpetual capital funding process versus the friction of the serial fundraising model of traditional private funds which can translate for investors into lower operating expenses and more focused, longer-term minded, investment portfolio management.

 Hortz: Can you share some ideas for advisors and asset allocators on how best to position this investment strategy and vehicle to their client portfolios?

Valli: Being able to offer a high yielding, risk-managed, lower volatility investment secured by the real assets of residential housing – combined with a strong track record in that space and a shortage of residential properties right now – makes this non-traded REIT very appealing to income-oriented investors. Reporting from Pitchbook and other investment research clearly indicates this is potentially a multi-trillion-dollar growth opportunity, and you can help your clients access this private market portfolio diversifier.

Tecotzky: We see the evolution happening in the residential housing market and we think we are at the early innings of a tremendous opportunity. Our firm is committed to working closely with advisors to provide analytical tools, support, and education to help them understand and position the non-traded REIT offering for their clients.

This article was originally published here and is republished on Wealthtender with permission.

About the Author

Bill Hortz

Founder Institute for Innovation Development

Bill Hortz is an independent business consultant and Founder/Dean of the Institute for Innovation Development- a financial services business innovation platform and network. With over 30 years of experience in the financial services industry including expertise in sales/marketing/branding of asset management firms, as well as, creatively restructuring and developing internal/external sales and strategic account departments for 5 major financial firms, including OppenheimerFunds, Neuberger&Berman and Templeton Funds Distributors. His wide ranging experiences have led Bill to a strong belief, passion and advocation for strategic thinking, innovation creation and strategic account management as the nexus of business skills needed to address a business environment challenged by an accelerating rate of change.