What role can global commercial real estate play in a portfolio?

Many aspects of everyday life revolve around a hub of commercial real estate.

Work, shopping, entertainment and living increasingly take place in commercially owned buildings. This centrality to everyday life means commercial real estate is an important tool for investors. It is also an asset class undergoing a period of democratisation, with more investors understanding the value it can bring to their portfolios.

In the traditional terms of risk-return profile, real estate typically sits between fixed income and equities. Real estate generally has a higher risk-return profile than bonds, and a lower risk-return profile than the majority of equities. But real assets, managed correctly, can blend the best of both in a risk-adjusted package.

Returns on equities tend to be largely driven by share prices rising and falling (capital appreciation and depreciation). Fixed income returns tend to be largely driven by coupon payments (income).

Real estate returns offer a useful and valuable balance of both capital appreciation and income. What’s more, in-demand real estate benefits from fundamental scarcity.

How do investors add commercial real estate to their portfolios?

Broadly, investors access real estate through what are termed the “four quadrants”, as follows:

Private real estate equity

Investments in private real estate equity can take two main forms. Investments could be in the form of directly held properties – investors buying, managing and selling physical buildings.

Alternatively investments in the assets may be indirect; accessed via private real estate funds or other vehicles. The key benefit of private investment is the lower measured volatility, driven by less frequent valuations of the underlying real assets. This comes at the cost of lower liquidity.

 Public real estate equity

Public real estate equity vehicles enable investors to access commercial real estate via listed real estate investment trusts (REITs) or real estate operating companies (REOCs). The advantages that public market options can offer include potential tax-benefits and enhanced liquidity. Shares are traded, even though the underlying assets are not, leading to greater volatility of returns, more akin to stocks and shares.

Private real estate debt

Private real estate debt typically involves (non-bank) investors becoming creditors. The underlying asset, in turn, serves as security for the loan. Debtors are contractually obligated to pay back the creditors’ principal in full, in addition to paying periodic interest payments over the life of the loan.

Public real estate debt

In contrast, public real estate debt focuses on publicly traded debt-like instruments such as commercial mortgage-backed securities (CMBS) and mortgage REITs. These instruments are secured by mortgages on commercial properties and/or mortgage-backed securities. The benefits of public and private debt are similar to these mentioned under private or public real estate equity.

Each of the above options provides potential benefits as standalone investments. By adding the features of several into portfolios investors are able to achieve diversification benefits and bespoke combinations of income, growth and liquidity to best suit their investment requirements.

Overlooked? The global real estate market universe

Global real estate has been relatively underexplored by individual investors until recently. Institutions have used the full suite of options in the real estate markets for many years. Now, the focus is on structures that make private assets more accessible to individual investors, such as wealth managers’ clients.

The global real estate market universe as a whole has grown by 4.9% annually since 20091 with annual transaction volumes surpassing $1 trillion on average over the past five years to end 2021. Individual investors account for a significant proportion of daily equities trades, but the ownership of private, especially more sizeable commercial real estate is currently relatively small. Rapid year-on-year growth is projected in this group as more suitable structures evolve.

“Traditional” commercial real estate sectors

Historically, commercial real estate has been differentiated into five ‘traditional’ sectors.

• Offices: properties occupied by employers to provide a workplace for largely desk-based employees
• Industrial & Logistics: industrial properties utilized for manufacturing activity and logistics or distribution properties that facilitate the movement and storage of goods
• Retail: high street shops, larger shopping malls, and out-of-town retail parks
• Residential: typically refers to multifamily rental housing blocks
• Hospitality: hotels that cater to both business and leisure travel

In recent years, there has been significant growth in what are termed “adjacent” real estate sectors, which represent extensions of the five traditional real estate sectors. These adjacent sectors often have enhanced features and represent more operationally intensive assets.

For example, traditional adjacent investment options to traditional “multifamily” residential projects could include senior housing, student housing or social housing. Each of these sub-sectors have attracted substantial investor interest in recent years due to potential diversification and enhanced income return benefits. But each of these subsectors also tends to require a different set of investment considerations and additional specialist management expertise.

Real estate strategies across the risk-return spectrum

Real estate equity and debt strategies can be broadly categorised by their risk-return profiles. At one end, investment grade real estate debt typically delivers the lowest return at the lowest level of risk. The underlying loans have a predefined income, as well as priority in the repayment of the loan, and from the proceeds of the sale of the underlying assets in the unlikely event of default.

At the other end of the spectrum, there are opportunistic equity investments, in which investors make more speculative assumptions about how to achieve the future value. They expect to be compensated for this risk with commensurately high returns. The proportion of total return on an investment derived from increased capital value versus income therefore corresponds to how high up the risk-return spectrum the investment is. Unpacking this in more detail, real estate risk-return profiles are influenced by the following characteristics:

• Physical condition of the building (including sustainability credentials)
• Asset location
• Creditworthiness of occupying tenants
• Occupancy level
• Lease length/nature
• Income profile, and
• Proportion of third party debt assumed within the capital structure (“leverage”)

Core real estate generally refers to strategies investing in stabilised, income-producing assets. These assets are generally well-located in major markets, leased on a long-term basis to high credit tenant(s), with a low level of debt. A subset of core real estate investments is referred to as “core plus”, which refers to investments in assets that are essentially core but with a minor notch-up in terms of risk profile (for example, the assets require minor remedial work or slight changes to operations to stabilise their income profile).

Value add real estate often involves investments into assets that need to be significantly repurposed to create the expected income and value. This repurposing might mean a change of use, a space reconfiguration, refurbishment or upgrade or a lease restructuring.

Opportunistic real estate typically refers to the wholesale redevelopment  of assets from the ground up, or investments in distressed situations (for example where the existing owner runs out of money). Often such investments use higher levels of borrowing to achieve the expected investment outcomes.

Inflation-linked performance

Commercial real estate has a strong history of successfully providing inflation protection for investors, driven by contractual rental increases factored into lease agreements. This has helped global commercial real estate investments to provide absolute and relative performance.

Diversification benefits

The chart, below, provides a summary of historic correlations between investments in global real estate and the main liquid global asset classes. The higher the correlation number, the more similar investment returns tend to be over time.

As can be seen, investments in private global real estate and global bonds have a negative correlation relationship. This means when the return for one of these asset classes goes up, the other goes down (historically). There has been a generally low, positive correlation between global real estate and equities. These low correlations between private real estate and other asset classes demonstrate how the inclusion of global private real estate within a multi-asset portfolio has the potential to improve overall portfolio diversification.

There is evidence to suggest that adding real estate to a diversified portfolio can improve the overall risk/return profile. Figure 5 shows that over the past ten years, including a 20% allocation to global real estate (comprising a 75% core allocation and 25% value add) in a 60:40 portfolio of global equities and global bonds, modestly increases overall returns and meaningfully decreases annualised volatility.

As with all private investments, performance is subject to investor expertise. Experience is vital, as is proximity to the underlying assets both geographically and operationally. For all individual investors seeking to access commercial real estate, the liquidity profile and governance provisions of the growing number of investment options available, must be factored into portfolio construction.