The Implementation: Real Estate for Investment Portfolios

Accessing Investment Strategies to Build Out Your Portfolio

By: Gavin Reiff, P.Eng., MBA, Vice President, Real Estate Advisory at Richter, a Business | Family Office. Gavin offers real estate advisory services to investors, owners, and managers of private real estate.

Contributor: Nicholas Kolobotos, Senior Manager, Real Estate Advisory at Richter

As originally appearing in Espace Montreal volume 33, #3, 2024.

Real estate is an asset class that serves a fundamental role within well-diversified investment portfolios. It is also a diverse asset class in itself, where through a careful selection process, investors may tailor their real estate investment exposure to suit a variety of macroeconomic conditions and their own approach to their risk versus return balance.

Understanding the underlying attributes of the real estate asset and investment structure may provide a useful framework to augment the selection process.

ASSET CLASSES

In general, each real estate asset class provides a unique investment exposure. Traditionally, there are four main asset classes within the real estate investment category being residential, office, retail, and industrial. A fifth category referred to as a “specialty” has emerged, being a catch-all terminology for real estate designed for specific purposes such as student housing, long-term care housing, data centres, hospitality, entertainment, outdoor storage, or agriculture, for example. Each of the specialty asset classes has formalized, with significant investment from global asset managers and pension funds, where the nature of their investment exposure is as varied as the traditional asset classes.

Asset performance is accessed through cash flows available to investors, where such cash flows are a function of revenues, cost structure, capital expenditures, and financing. Revenues are realized through the leasing or sale of space, which is largely determined by local and macro market conditions.

Certain asset classes are viewed as defensive with their cash flows demonstrating greater resiliency under varying economic environments. Examples include residential rental apartments, where demand is stable considering people need a place to live, and industrial where tenants are typically under long-term lease contracts while the services they provide (e.g., food storage, medical equipment, commodities) are also essential to a functioning city and economy.

Conversely, exposure to cyclical real estate sectors offers an alternative risk return profile.  For example, the hospitality sector (hotels, resorts, restaurants) is comparatively more reliant upon personal and business discretionary spending that increases in periods of economic growth and investor confidence. These assets and operations tend to have higher operating costs to maintain service levels, and often require significant upfront and recurring capital investment in furnishing, materials, equipment, and features to create a specific atmosphere.

Other real estate asset classes provide investment exposure to emerging themes and sectors. Data centres, buildings specifically designed for efficient operation of computer servers, generate cash flows from technology sector tenants that require capacity for cloud computing. Traditional real estate assets, such as farmland, are available for investment to gain exposure to commodities or scarcity of arable lands.

COST STRUCTURE AND CAPITAL EXPENSES

The cost structure and capital expenses, which reflect costs associated with operating and maintaining the asset is largely influenced by its use, vintage, physical condition, format, and installed building systems.

This feature is often overlooked by prospective investors. Should an asset be in an advanced state of disrepair, it may not generate sustainable cash flows, through revenue degradation or an onerous amount of capital costs required to maintain building safety.

An investor should be in a position to assess the risk of realizing sustainable revenue streams and be confident in his or her ability to make optimal capital maintenance, capital repairs, and operational decisions for the building to operate in a long-term efficient manner.

GEOGRAPHIC CONSIDERATIONS

Geography has a considerable influence over real estate investment decisions, as it’s a proxy for investment in the underlying economic attributes of a given geography. Investment decisions are commonly based upon assessment of economic fundamentals such as population and employment growth.

In Canada alone, the differences in investment fundamentals between cities are vast. Toronto, being the economic hub of Canada and responsible for 20% of the country’s GDP[1], represents 31% of real estate transactions year-to-date in 2024[2]. The over-representation of investment volume is attributed to a combination of several factors that include it being the financial capital of Canada, its established business ecosystems and employment opportunity, and its population density and growth.

Other examples include Edmonton, Winnipeg, Ottawa, Quebec City, and Halifax, where Provincial and Federal governments have significant employment presence, draw investor attention where those jurisdictions offer investor access to relative economic stability.

VALUE CREATION CYCLE

The dynamic between investment risk and return also varies depending on the investment entry point in the real estate lifecycle. Traditional real estate investment entry points include land and entitlement, development and construction, operations and optimization, and renovation and repurposing.

In general, stable income producing real estate possesses the lowest level of risk. By nature, the building exists, and it presumably has contractual in-place leases that provide a certain level of assurance the asset will generate revenue. Assets that have not maximized their generation of cash flow, have a greater level of risk and in-turn an investment entry point should generate a higher return. Investment in assets not sufficiently advanced to generating sustainable cash flows, as within development and construction phases, demand a return premium to compensate investors for execution risk. Similarly, investment into non-optimized assets, that may require extensive capital expenditures or do not possess a competitive format, also demand a return premium for risk associated with repurposing the asset.

INVESTMENT ACCESS

There are three traditional ways to gain investment access to real estate. This includes acquiring units of a public Real Estate Investment Trust (REIT), acquiring units in a private real estate partnership or fund, and direct ownership. The typical minimum equity investment requirement is substantially different for each, yet so is the typical return profile, holding period, and liquidity profile.

Investing in public REIT units requires a nominal amount of capital and offers high liquidity. The expected return profile from a REIT is relatively muted as they are designed to return a consistent yield from the underlying stabilized assets.

Moving up the risk spectrum includes investment in private real estate partnerships or funds that may generate a higher return through engaging in value-add activities. If such activities are successfully executed, the asset would generate both a capital return and consistent yield. Investors should consider that private partnerships and funds are generally not liquid, as value-add activities undertaken at the asset level take time to complete and the asset may not be positioned for sale or to generate income for a similar duration.

Taken one step further, investing in direct real estate ownership typically requires a significant amount of capital commitment and offers only limited liquidity in certain economic environments. Notwithstanding, this approach allows investors to exercise greater strategic and operational control over their assets with the potential to achieve superior returns. Successful execution of value-add activities under direct ownership may generate substantial capital appreciation and provide a consistent yield, though it’s important to note that direct ownership generally involves higher risks and longer investment horizons.

Gaining investment exposure to real estate within an investment portfolio and understanding the specific risk and return features of each asset, requires thoughtful research and careful consideration. There are several layers of complexity related to asset class, geography, and value-creation cycle. While caution should be exercised, the right investment can substantially and meaningfully contribute to one’s investment portfolio. Experienced professionals with unique expertise in the field should advise and highlight inherent risks before an investment decision is made.

This article is for informational purposes only and is not intended to be investment advice. It’s best to discuss your personal situation with your advisor, to get guidance tailored to your specific portfolio.

ABOUT US

Richter is a Business | Family Office that provides strategic advice on business matters and on families’ financial and personal objectives across generations. With close to 100 years of experience advising at the intersection of family and business, Richter has developed an integrated approach to help business owners find sustainable success. Whether business, personal, or both, Richter is uniquely positioned to address the needs of Canada’s most successful entrepreneurs, private clients, business owners and business families and helps them chart a clear path to shape their legacy for the future. Founded in 1926, Richter’s 600-person multidisciplinary team continuously innovates to create value for our people, clients, and community in Canada and in the US.

Within Richter is Richter Family Office (RFO), one of the largest, fully independent, multi-family offices in Canada. We’ve been assisting some of the most successful business families for close to 100 years. RFO has unique expertise advising families holistically with wealth management, finance, operations, lifestyle management, governance, next generation preparation and financial literacy, tax, estate planning and life insurance, philanthropy advisory, risk management and cybersecurity, and real estate advisory. RFO has relationships with best in class, global and national, fund managers, as well as with real estate operators and developers.

[1] https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=3610046801

[2] https://mktgdocs.cbre.com/2299/d40e905a-5937-47b8-9d77-f13efda3ebd7-1497146776/v032024/canada-investment-overview-q2-2024.pdf