Private real estate funds dramatically underperform two of their private markets peers — buyout and venture capital funds, according to new research.

Although the reasons for the big gap in returns can’t be determined from the study, the researchers put part of the blame on some investors failing to hold real estate managers accountable when funds underperform.

According to a recent paper from Da Li and Timothy Riddiough, two researchers who study private equity and real estate finance at the University of Wisconsin, Madison, the average annual internal rate of return (IRR) of private equity real estate funds from 2011 to 2021 was 7 percent, significantly lower than the IRR of buyout funds (14.5 percent) and venture capital funds (10.9 percent). The paper was based on an analysis of over 2,738 liquidated PE funds in real estate, buyouts, and venture capital strategies.

According to the paper, managers’ first funds were far better performers than subsequent funds. The average IRR of real estate funds was 14 percent for managers’ first fund launches — or Fund I’s. For a manager’s Fund V and Fund VI, performance declined to 8.1 percent and 4 percent, respectively. In contrast, the average IRR for buyout and VC strategies was fairly consistent from one fund to the next.

According to Li and Riddiough, the conventional narrative around private equity fundraising is that only managers with the best track records can survive to raise subsequent funds. “Altogether, comparative results by major fund category indicate that [buyout] and VC funds broadly conform to the conventional ‘survival of the fittest’ narrative,” they wrote in the paper.

But in real estate, the average fund performance significantly declined after Fund IV. As a result, less skillful real estate fund managers remained viable businesses — and ready to raise more money from investors — despite a history of poor performance.

It’s also harder to generate positive alpha in private equity real estate funds than in other types of PE funds, according to Li. “We found that there’s almost zero or even negative alpha for real estate,” Li told Institutional Investor.

Reddiough said they “don’t have any definitive answers” to why the anomaly in the manager selection process exists in real estate funds. One possible explanation is that unlike buyout and VC funds, public pension funds represent the majority of investors in real estate funds. Public pensions, argue the authors, don’t always choose asset managers based solely on quantitative measures such as a long track record of delivering high returns.

“Prior literature [shows] that public pension funds are subject to regulations, political influences, and organizational frictions that influence the investment process.”

For example, the paper suggests that public pensions analyze non-financial factors when choosing managers. These factors can include things like environmental, social, and governance considerations and can potentially limit public pensions’ ability to maximize financial returns.

In addition, “pensions fund investors, for some reason, seem to believe that real estate is less risky than other forms of alternative investment,” Reddiough said. As a result, they’re not looking for the highest returns from these funds. “Da and I respectfully disagree with that perspective.

Staffing issues at pension funds may also explain why the worst-performing real estate fund managers end up surviving and raising money for new generations of funds. “Low pay and high staff turnover are known to be significant issues at many public pension funds,” according to the paper. What’s more, the research suggested that many pension funds hire investment professionals from real estate fund managers, who want to maintain these relationships. This may make it harder for pension funds to fire real estate managers, even if they perform poorly.