Key Takeaways

  • If you’re looking to boost your portfolio returns, the key may lie in targeting private markets, which offer opportunities to earn higher returns than public markets like the stock market.
  • Commercial real estate offers a prime example of how structural inefficiencies in private markets can position investors to earn superior returns by leveraging operational and informational advantages.

Why Institutional Investors Outperform

What if I told you that you could substantially boost your portfolio returns without taking on excessive risk? Although this may sound too good to be true, major institutions figured out the key to doing this a long time ago—and it isn’t what you might assume.

As of 2015, the average equity mutual fund investor earned a 30-year annual return of roughly 3.7%. By contrast, the Yale endowment generated an approximate 13% annual return over the past 30 years.

While you may be thinking that the Yale endowment’s superior returns are clearly a product of in-house skill, expertise, and access that retail investors can’t replicate, you’re missing a key part of the story. While all of this is true, a major source of Yale’s success lies in its superior investment strategy. Yale continuously maintains a relatively high allocation to private market investments. Specifically, the endowment currently allocates over 70% of its portfolio to asset classes that are classified as alternative investments.

Unlike retail investors, large institutional investors like pensions and endowment funds typically allocate a substantial percentage of their holdings to private non-traded investments. Thanks to new technologies, the options for retail investors looking to boost their private market exposure are growing rapidly—and the data to back up why more individuals are seeking out private investments is self-evident.

However, the reason private markets investments are so profitable is not as widely understood, and may come as a surprise: inefficiency.

Inefficiency Gives Private Markets Their Edge

Crack open any Econ 101 textbook, and you’ll likely find at least a chapter devoted to the Efficient Market Hypothesis, which posits that in markets with large numbers of participants, low transaction costs, and freely available information, it is virtually impossible to “beat the market.” This is because all relevant information is baked into the price, and therefore buyers act as “price takers.”

One example of this is the stock market. With $42 trillion in domestic trades annually, extremely low transaction costs, and intense regulation, opportunities to earn above-market returns are virtually absent, even for the most well-informed, operationally advantaged investors.

By contrast, inefficient markets are characterized by limited numbers of participants, fewer opportunities to dispose of assets, less widely available information, and higher transaction costs, or barriers to entry. As a result of these features, buyers in private markets, like real estate, have the opportunity to negotiate the prices of assets, and translate managerial competence into added value.

Examining Inefficiency in the Private Commercial Real Estate Market

The world of commercial real estate offers a window of insight into how private market inefficiency creates opportunities to earn above-market returns.

Here’s a basic example: there’s retail strip mall that’s fallen into disrepair. The current owner has neglected to maintain and update the property, and as a result, tenants are leaving as their leases expire. The property’s vacancy rate—or the proportion of the building that is unoccupied—is very high, and the building is generating a sub-par cash flow compared to other retail buildings in the same neighborhood.

A local developer knows that the retail market is oversaturated in the area, but that there’s unmet demand for high-end apartments. As a result, there’s an opportunity to add value to the strip mall by tearing it down, and turning it into a complex of high-end apartments.

Right off the bat, the developer has several advantages, including:

  • Knowledge and Track Record: There aren’t many buyers with the in-house expertise, operational experience, capacity to perform due diligence, and access to capital needed to transform a dilapidated strip mall into a luxury apartment complex, so there aren’t many buyers competing for the asset. The developer’s experience in the industry eliminates the need for a broker —a substantial cost that could act as a barrier to entry for other prospective market participants that might otherwise bid up the price of the asset.
  • Information Asymmetry: This is an opaque market where information is not widely disseminated. The developer likely learned that the asset was for sale through local contacts. Since the building owner wasn’t advertising, other potential non-local buyers didn’t even know the property was on the market.
  • Limited Competition: Because the developer faces limited competition, and because the seller knows that the pool of people interested in buying his property is relatively small, the developer is able to negotiate a price below what she would likely pay in a more competitive environment.

Once the developer has acquired the asset, she is then able to rely on her industry knowledge and established relationships with local contractors and management companies. All of this translates into a successful, occupied luxury apartment development that is now worth millions more than what the developer paid both to acquire the site, and to transform it.

If this hypothetical example sounds far-fetched, it isn’t. Residential conversions of alternative property types have been cropping up all across the country thanks to robust demand for apartments and the return potential made possible by structural inefficiencies in the real estate market.

Investor Implications

The net-net is simple: By allowing investors to negotiate prices and leverage informational and other advantages, inefficient private markets offer opportunities to earn superior returns with a magnitude and consistency that is not achievable in efficient public markets like the stock market.

Moreover, investing in private markets to achieve superior returns has never been easier or more affordable than it is today with Fundrise. We’ve created the first goal-based, technology-enabled investment management service that allows you to take advantage of the alternative investment opportunities created by private market inefficiencies easily and seamlessly. You no longer need to be a high net-worth individual or have decades of industry experience under your belt to capitalize on the return potential of private markets. By investing on Fundrise, you can build a portfolio of private-market real estate assets quickly and effortlessly. We’ll bring the industry expertise and handle the negotiating. All you need to do is get ready to boost your portfolio returns.