How Do Real Estate Hedge Funds Work?

Summary: Where do real estate hedge funds earn their money and how do they operate? This page looks at their investment strategies.

By definition, real estate and hedge funds ought not to work together. Hedge funds are fast moving, leap into and out of assets quickly and are looking for the maximum in short-term profits. In contrast, property is the investment definition of illiquid, it is not easy to break a property into shares and sell a small part of it. It is immovable and often has a high amount of debt tied to it.

How can one operate with the other?

Of course, in the world of the hedge fund manager, where there is a profit to be made, there is a way!

The more obvious route of buying actual buildings does not fit the hedge fund model very well. Therefore, in terms of large investors taking a stake, this is more likely to the realm of companies listed on the stock exchange, private equity funds or specialist property funds (these are likely attached to large pension funds for example).

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Real estate hedge funds look for their opportunities in the very companies just mentioned. They trade into and out of property companies that are listed on the stock exchanges of the world. This provides the liquid market they require for fleet-footed trades and also provides the specialisation that can help to attract large investors.

This obviously provides new challenges for the hedge fund manager. Not only do they need to understand the swings and moves of the stock market, and the real estate companies, but they also need to be quite a savvy property investor because their skill in spotting the companies with winning or losing portfolios will determine much of their overall results.

There are also geographic risks. While it is understandable that a fund manager might know something about the property market in New York or London, do they know as much about the market in Idaho, Nebraska or Liverpool?

It is also worth pointing out that a real estate hedge fund has the opportunity - should it choose - to make a profit if property markets decline. Their ability to 'sell short' a company or sector could prove to be valuable.

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No discussion of real estate hedge funds would be complete without a mention of mortgages...

It seems quite reasonable to imagine that most real estate hedge funds would be investors in the mortgage industry in some way. After the experience of the financial crisis in 2008, it seemed as though everyone and everything was invested in the US mortgage market, so why not hedge funds?

Considering the ill-fated risks that were taken and the subsequent repossessions, bankruptcies, margin calls and company closures, it is also quite possible that many funds in this sector will he holding US mortgage debt as an 'asset' for many years, if not decades, to come.

Therefore, on top of the usual risk warnings about hedge funds, it is worth considering very closely the assets being held by any fund being considered for an investment and whether or not those assets include sliced-and-diced tranches of mortgage books.

Perhaps the most successful real estate hedge fund is that operated by John Paulson. He took a major position against the property bull market in the United States which paid off handsomely in 2007 and 2008. He had rightly predicted that the property market was heading for a fall and that prices and mortgage debt would be adversely impacted. By selling the market short - and being one of the few people on Wall Street doing so - he was able to make enormous profits in a very short period of time.

There were other funds that profited, but none so spectacularly. Some of the other funds had sold short the shares of the main property agencies or retail mortgage lenders, or of course, Lehman Brothers since they were very involved in the structured mortgage market.

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