The international route to a truly diversified property portfolio
Most investors are aware of the importance of portfolio diversification, but many still tend to favour domestic markets. This home bias is particularly prevalent amongst investors in direct real estate (“bricks and mortar” as opposed to tradeable property securities). We argue that the best opportunities lie in a portfolio that is diversified internationally.
Home bias is perhaps understandable in direct real estate, given its inherent lack of liquidity and the need for extensive due diligence and expertise to invest successfully. However, it could be equally well argued that these same characteristics should make investors more keen to diversify abroad in a search for more consistent returns.
Several property markets have matched or comfortably outperformed returns from both developed market equities and bonds over a number of periods. Moreover, the composition of these returns is a key attraction. Real estate still provides a superior income return to bonds in most markets. Capturing this premium often requires a willingness to invest abroad.
Direct real estate also offers the potential for risk reduction. The volatility of returns varies quite widely from one region to another when viewing “unsmoothed” returns calculated using a mathematical approach that attempts to recreate the volatility intrinsic to financial markets.
When we look at other relevant factors to assessing real estate risk, such as lease terms, covenant strengths, structural changes etc., we also observe that this can greatly differ between property markets. It should therefore be possible for investors to reduce risk by allocating assets among a number of foreign markets.
We would argue that differences in lease terms and political risk mean investors should then focus on a limited number of cities with key characteristics. These include a diverse economy, skilled labour force, good infrastructure, proactive local government and good retail and leisure facilities. Attractive cities include major ones, like Berlin, London, Los Angeles, Munich, Paris, Shenzhen and Tokyo, and smaller ones, like Bordeaux, Cambridge, Mannheim and Malmö.
We also found that annual returns from different markets are seldom in synch. Thus, while the UK market was one of the first to be hit by the credit crunch in 2007, it was also the first to recover in 2009. The US was just behind and then experienced a much stronger recovery than virtually any other region.
This misalignment of property cycles suggests that an international portfolio should not only diversify returns, but also reduce risk. The potential for diversification is further underlined by the relatively low correlations displayed by most markets with each other.
How much to invest internationally and where will ultimately depend on the investor’s starting point. Some investors are principally looking for superior total returns, while others are more concerned about achieving a certain level of income. Either way, international real estate should offer more security for investors than concentrating assets in their own property market.
 By way of comparison, the local currency returns for the MSCI World equities index were 13.7% over three years, 10.2% over five, 5.5% over 10 and 6.8% over 20 years, and for the Citigroup World Government Bond Index 3.3%, 4.0%, 3.7% and 4.7% respectively over the four periods.
 Amongst other things, this takes account of the inevitable lag and infrequency of real estate valuations, as well as valuers' caution and their tendency to understate both peaks and troughs in market prices.
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