What role can global commercial real estate play in a portfolio?
Here we look at how sophisticated private wealth investors are increasingly exploring the benefits of combining various commercial real estate strategies in their portfolios.
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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 real estate has consistently been one of the key capital markets for investors around the globe.
While estimates vary1, the total value of global property is estimated to stand at around $380trn – dwarfing the global equity (c.$100trn) and bond (c.$130trn) markets. This scale is underpinned by fundamental scarcity as growing populations and ever rising urbanisation rates mean physical property can provide a tangible store of wealth.
Today’s real estate markets
The Covid-19 pandemic accelerated several changes in how we interact with the real estate in our towns and cities, channeling demand for some sectors at the expense of others. Just as the dust was beginning to settle, the real estate markets have, like much of the wider economy, been buffeted by the onset of the interest rate tightening cycle. The speed and coordination of this cycle across the globe has deepened the disparities between winners and losers, setting the stage for a sequential investment opportunity for those with the tools to identify and execute strategies in a repriced environment.
Meanwhile, we have seen a steady institutionalisation of new “adjacent” and “emerging” real estate sectors driven by structural trends such as shifting demographics, as investors searched for yield and further diversification. What connects these adjacent sectors is that they often have favorable supply/ demand dynamics based on relatively lower market adoption, and typically carry a yield premium to more established sectors given the additional operational management required to own and oversee them effectively.
For example, traditional multifamily residential’s adjacent investment options include senior housing, student and social housing, and other subcategories. Each of these sub-sectors have attracted substantial investor interest due to potential diversification and enhanced income return benefits relative to more mainstream residential formats. But each of these subsectors also tends to require a different set of investment considerations and the development and maintenance of specialist management expertise.
How do investors add commercial real estate to their portfolios?
Broadly, investors can access real estate through two main categories:
Public real estate equity
Public real estate equity vehicles enable investors to access commercial real estate via listed real estate investment trusts (REITs) and other listed companies including developers. The advantages that public market options can offer include potential tax-benefits and liquidity. However, shares in the funds are traded, even though the underlying assets are not, leading to greater volatility of returns, more akin to stocks and shares.
Private real estate equity
Investments in private real estate equity can be executed through several structures. Investments could be in the form of directly-held properties – investors buying, managing and selling physical buildings (usually called “assets”). Alternatively, investments in the assets may be indirect; accessed via private real estate funds or other “commingled” vehicles. This could include private real estate operating companies (REOCs) and platforms that are analogous to their listed counterparts.
The key benefit of private investment is the lower measured volatility, driven by less frequent valuations of the underlying real assets. However, this comes at the cost of lower liquidity. For individual investors, recent innovations in semi-liquid structures seek to strike a balance between private market exposure with enhanced liquidity and the preservation of value for remaining investors. These have been a major growth area for the industry.
Real estate strategies across the risk-return spectrum
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 most equities. But real assets, managed correctly, can blend the best of both in a compelling 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 (referred to as income). Real estate returns can offer a useful and valuable balance of both capital appreciation and income. Real estate strategies can be broadly categorized by their risk-return profiles. Unpacking this in more detail, real estate risk-return profiles are influenced by the following characteristics of the underlying investments:
Physical condition of the building (including sustainability credentials).
Sector and functional use.
Asset location.
Occupancy level.
Lease length/nature.
Credit worthiness of occupying tenants.
Proportion of third-party debt assumed within the capital structure (“leverage”).
As shown in Figure 2 below, in the real estate industry lexicon, the combination and degree of each of these factors is distilled into a number of categories and strategies.
“Core” and “Core Plus” 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 leverage. Core plus investments are essentially core but require minor management to stabilise their income profile and modestly higher financial leverage may be utilised.
“Value add” real estate involves investments in assets that need to be significantly repurposed to create the expected income and value. This repurposing might mean any or all of a change of use, a space reconfiguration, a (sustainability-led) refurbishment or upgrade, a lease restructuring, rebranding, or improvements to operational efficiencies. This can also include the aggregation of portfolios and platforms to capture potential portfolio premia and enterprise value.
“Opportunistic” real estate typically refers to the wholesale redevelopment, or complete development, of assets from the ground up and investments in distressed situations (e.g. when the existing owner can no longer afford debt or operational costs associated with the assets), and therefore makes the most speculative assumptions about the future prospects of the market and asset. Often such investments employ significantly higher levels of financial leverage to achieve the expected investment outcomes. Investments in developing or emerging markets can also be included in this category.
Real Estate in a Multi-asset Portfolio
There is evidence to suggest that adding real estate to a diversified portfolio can improve the overall risk/return profile. Figure 3 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, highlighting its diversifying potential.
This portfolio impact is derived from two key attributes which real estate investment is associated with:
Inflation-linked performance
Commercial real estate has a strong history of successfully providing inflation protection for investors, driven by either contractual rental increases factored into long-term lease agreements, or the rapid repricing of short-term contracts (e.g. in residential or hospitality assets) which allow for pass through of background price pressures. This attribute has helped enable global commercial real estate investments to provide solid absolute and relative performance through inflationary cycles.
Figure 4 demonstrates in three markets from different continents how this relationship has tended to hold over time. However, it is important to note that these principles are not universal – as can be seen in the UK context in 2020 to 2023 where, due to a much lower prevalence of contractual rent increases in-line with CPI, acute inflationary pressure at least temporarily outpaced income growth.
Diversification benefits
Figure 5 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 that when the return for one of these asset classes goes up, the other goes down (historically). On the other hand, 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 show how the inclusion of global private real estate within a multi-asset portfolio can improve portfolio diversification at scale.
Institutional investors have enjoyed the potential benefits of private real estate investment for many years. In an asset class which has traditionally required very substantial upfront investment to participate, innovations in fund structures are opening up these investments to a wider pool of investors.
As with all private investments, performance is subject to investor expertise. We believe proximity to the underlying assets both geographically and operationally is vital. And of course, for all individual investors seeking to access commercial real estate, the liquidity profile and governance provisions of the growing number of investment solutions available must be factored into portfolio construction.
Source:
[1] Savills, 2023
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