Diversification is currently high on the agenda of many investors, arguably more than ever before. But unless investors know why an asset type offers diversification, they can’t be certain of its reliability. A negative correlation between two asset classes could be a coincidence.
We explore why direct real estate has usually been a good diversifier when paired with equities and bonds, and why multi-asset portfolios could benefit from exposure to the asset class.
One of the attractions of real estate is to reduce volatility in a multi-asset portfolio.
To some extent, the relative stability of real estate returns is artificial. The apparent stability reflects the fact that real estate is less liquid than financial assets and consequently, its performance is based on valuations, rather than transaction prices.
However, part of the difference is genuine. The income from real estate has grown in line with inflation over the long term and while it has not matched the income growth from equities, it is comparatively stable. Tenants are legally obliged to pay the rent, whereas companies can choose if they pay a dividend.
Since 2000, the annual change in the income from a real estate portfolio has varied between 7% (2004) and -10% (2020) in the UK and between 5% (2006) and -6% (2020) in the US. By comparison, the annual change in income on an equities portfolio has ranged between 14% (2005) and -26% (2020) in the UK and between 51% (2003) and -28% (2008) in the US.
Clearly, 2020 was an extremely challenging year. Before the pandemic, the biggest annual fall in income from a UK real estate portfolio was -1% in 2009, during the global financial crisis (GFC). But while lockdowns meant that many non-food retail and leisure businesses were unable to pay their rent, landlords were sometimes able to mitigate the impact on total returns by negotiating with tenants to extend their lease or cancelling a forthcoming break clause.
The other way in which real estate can reduce the volatility of returns from a multi-asset portfolio is diversification of returns. Real estate returns generally dance to a different tune than equities and bonds.
Long-term data for Europe and the US suggest that the correlation coefficient between real estate and equity total returns is between 0.1 and 0.3 and the correlation between real estate and bond returns is even weaker at between 0 and -0.2.
Why is real estate a dependable diversifier?
Although government bond yields provide an anchor for real estate yields in the medium term, the two do not move in parallel in the short term. This is because real estate yields are also heavily influenced by the outlook for the economy and for rental growth.
A lot depends on why bond yields are changing. For example, if bond yields are rising because the economy is growing strongly and there are concerns about inflation, then real estate yields could fall. This happened in the late 1990s and between 2005-2007. Real estate could be a useful hedge in this situation.
The main reason real estate has been a good diversifier of equity risk is that it typically “responds” rather than “forecasts”. Equities are a leading indicator of the economic cycle, real estate is a coincident, or even a lagging indicator. There is a forward-looking element to real estate yields, but rents are driven by the current demand and supply of commercial space. In other words, what is happening in the “real economy”.
Less diversified during the GFC, but returned to form
The one period when real estate failed to provide much diversification against equities was between 2005-2010, when real estate returns were driven primarily by the availability of bank debt.
Through 2005-2007, the rapid growth in bank lending and development of the commercial mortgage-backed securities (CMBS) market drove real estate yields down and pushed up capital values and returns. The opposite then happened through 2007-2010. Credit markets froze and there was a vicious cycle of distressed sales and falling real estate values. Since the GFC and subsequent tightening of financial regulations, banks have taken a more cautious approach to lending. Real estate has once again followed a different path to equities, helping to smooth portfolio returns.
Private commercial real estate debt
The more cautious approach of banks since the GFC has left a gap in the market for private commercial real estate debt funds. Like bonds, private commercial real estate debt provides investors with a stable income over the life of the loan and a certain date for re-payment, but typically with a higher yield than investment grade credit.
While there is a risk of default, this can be mitigated by the terms agreed at the outset of the loan. For example, lenders can insist on a “cash sweep” to receive all the rent, if the interest cover ratio falls below a pre-agreed level. Private real estate debt can also be structured to pay either floating interest rates - to provide a natural hedge against rising interest rates and inflation - or fixed interest rates, to be used within a liability matching portfolio.
Securing a diversified exposure to real estate
Paradoxically, while “bricks and mortar” real estate is a good diversifier of equity and bond risk, it is quite difficult to get a diversified exposure to real estate. In part this is because most buildings have a single owner, so investors cannot simply track the market by buying all the constituents in a real estate index.
In addition, returns are typically unique to individual properties. Even neighbouring buildings can deliver quite different returns in the short term, depending on the quality of the internal space, the tenant’s covenant and the unexpired lease term.
That means there is plenty of opportunity for skilled investors to add value and deliver superior returns. However, it can be frustrating and expensive from the perspective of building a balanced portfolio. Given that the average lot size of an investment grade property is $33 million, a 20-asset portfolio would require a minimum of $666 million.
It is also important not to confuse geographic spread with diversification. One trap which some investors fall into is to focus on major cities such as Hong Kong, London, New York and Tokyo. These cities are all financial centres, and their office markets are quite highly corelated, because they depend on investment banks and their advisers. The key, therefore, is to identify what drives local economies and invest in a mix of financial centres, tech hubs, industrial cities, university cities and government administrative capitals.
What drivers of diversification stay the course?
Correlation coefficients can be a useful method for assessing diversification, but they are not set in stone. Past correlations are not necessarily a guide to the future. The ability of real estate to provide diversification against equities and bonds reflects its hybrid nature. Income streams are contractually protected like bonds and unlike equities, but the potential for income growth means that real estate yields are not mechanically linked to bond yields.
Certainly, the fact that real estate is a physical asset means that there are additional risks to consider compared with equities and bonds, but these are manageable with the right manager, with the appropriate experience.