The Philosophy of Construction: Real Estate for a Well-Crafted Investment Portfolio
By: Robert Hall, CPA, CFA, Senior Operations Manager with Richter Family Office, a Business | Family Office. Robert oversees RFO’s private real estate investments and back-office operations.
As originally appearing in Espace Montreal volume 33, #2, 2024.
Real estate is often viewed as a solid investment that can only go up in value, with little thought given to the many characteristics that can affect its outcome or its role in an investment portfolio. It can be a great addition that helps diversify an investment portfolio and it often provides a source of income return which can complement other portfolio investments or strategies. There are however certain attributes that investors should be aware of before investing heavily into real estate. Industry professionals will consider the different types of real estate, how and where to access it, and how it complements their other investments before deciding to invest. These considerations may not always be apparent to the average investor.
It may seem that all real estate is homogenous in nature, but in practice it is not as the space is diverse, with many factors influencing the result, and these should be considered before determining whether a certain real estate investment is appropriate for one’s portfolio.
GENERAL PORTFOLIO CONSTRUCTION – TRADITIONAL AND ALTERNATIVE ASSET CLASSES
Havingexposure to different asset classes is a cornerstone of a well-crafted investment portfolio and helps to ensure that the portfolio is appropriately diversified. Asset classes do not all move in the same direction at the same time – a financial concept known as correlation. Some assets are more positively correlated – meaning they tend to move in the same direction, either up or down, at the same time – while others are more negatively correlated, meaning they tend to move in opposite directions. Exposure to different asset classes, such as stocks and bonds, for example, generally minimizes overall portfolio volatility, and typically results in a better risk-adjusted return profile. This is why seasoned investors and portfolio managers tend to focus more on the “risk-adjusted return” when investing, which is a rate of return calculation that incorporates the degree of risk of an investment, as measured against the volatility or fluctuation in the investment’s price. Given that real estate over the past 15 years has demonstrated a very low or negative correlation to the stock market,[1] investors should end up with better risk-adjusted returns by adding real estate exposure.
Investors commonly think in terms of three traditional asset classes: stocks, bonds, and cash or cash equivalents. Institutional investors usually have a dedicated fourth allocation to alternative assets, which are assets that do not fall under the three traditional asset classes because they behave differently and/or have unique investment characteristics. There are many types of alternative assets and real assets, which includes real estate, is one. Other alternative asset types or sub-classes include private equity, private debt/credit, hedge funds, and commodities, among others.
Alternative assets tend to be illiquid. Private real estate is a perfect example of an illiquid asset because it cannot be easily sold or converted to cash, as it could take many months for a sale transaction to be completed. Real estate that trades on a public stock exchange, or that is included in a publicly traded Exchange Traded Fund (ETF), or in a publicly traded Real Estate Investment Trust (REIT), on the other hand, is liquid (meaning easily traded) in nature. These investments behave similar to other stocks traded on public markets and for these reasons, is often included in the stock asset classification.
Private real estate is traditionally broken down into four sub-categories: Office, Retail, Industrial (collectively these three are known as commercial real estate) and Residential, which has three further sub-categories, Single Family properties, Condominiums and Multifamily properties, which are commonly known as rental units or apartments. These four sub-categories are the most common ways to invest in private real estate and are sometimes referred to in industry as “the four real estate food groups.” However, as real estate investing evolves, new real estate sectors are beginning to gain prominence. Self-storage facilities, health care & life sciences (research & development facilities), data centres (to support the growing demand for cloud and artificial intelligence computing), and hotels and hospitality (short stay and extended stay properties) are some examples of the emerging investable real estate sectors. Finally, there are also infrastructure projects that have a real estate component to them, however it is challenging for individuals to invest into infrastructure as these have a high cost of access – think, owning an airport or a waste management facility, whereas real estate is generally more easily accessible due to its lower price point, greater availability, and variety. Most professionally managed portfolios have a higher allocation of real estate versus infrastructure projects for these reasons. Deal access and potential value drivers are also variables to consider when constructing a real estate portfolio, as well as geography, development phase, and the sub-sector type. This is a broader topic that will be elaborated upon in a future article from our team at Richter.
Institutional investors traditionally followed what is referred to as the 60/40 model of investing – wherein 60% of their assets were invested in stocks and the other 40% in bonds. For the past three decades, the 60/40 model has gradually evolved to reflect the relatively new class of alternative assets. Institutional investors’ allocations to alternative assets, including private real estate, grew from 6% in 1999, to 22% in 2009,[2] and have remained stable since then, settling in at 23% in 2023.[3] For the High Net Worth (HNW) investor, alternative assets are generally a smaller allocation of their assets, more to the tune of 9.1% in 2022, according to a Cerulli Associates report issued in 2023,[4] but are expected to become a larger allocation in the future as the HWN investor gains familiarity with the asset class and it becomes more accessible through the banks and brokers’ marketing channels. Why is there a difference between institutions and HNW investors? Institutions are governed by their experienced Investment Committees which approve asset allocation policies whereas HNW individuals determine their own risk tolerance for real estate; and so, there is a lot of variability in HNW individuals’ real estate allocations depending on how said individuals view or “feel” about real estate as an investment.
Once an investor has decided to add real estate to their portfolio, should the exposure be made via public or privately traded real estate? Unlike private real estate, publicly traded REITs have a high correlation – roughly +0.80 on a scale of –1.0 to +1.0, per Alternatives by Franklin Templeton[5] to the US stock market, which means REITs tend to mostly move up and down in value at the same time as the US stock market, providing less of a diversification benefit when added into a portfolio of publicly traded stocks. Conversely, replacing publicly traded REITs with private real estate should benefit the investor as the correlation of private REITs to the US stock market is -0.28, providing better diversification benefits. According to Hines’ “Why Real Estate Now” report issued in February 2024, for the 10 years ended December 2022, a portfolio with a 20% allocation to direct real estate, 50% to stocks and 30% to bonds outperformed a 60%/40% portfolio of stocks and bonds and the same held true for the one, three, five and ten year periods.[6] Both public and private real estate have a role to play in a portfolio, however, the appropriate allocation to each is dependent on the goals and needs of the investor.
REAL ESTATE, AND THE INSTITUTIONAL INVESTMENT PORTFOLIO
Institutional investors typically gain market exposure to real estate in three ways. Firstly, by purchasing publicly traded real estate stocks, REITs or ETFs which are easily accessible as they trade on a stock market but are subject to market sentiment as well as the idiosyncratic risk of the underlying real estate company. Secondly, by subscribing to professionally managed real estate funds which invest in private real estate – in this case the fund manager selects the real estate properties. Thirdly, they invest directly into single private or direct real estate property. Conversely, for retail investors, publicly traded stocks, REITs or ETFs are the most common choice due to their ease of access and implementation, and private real estate is often inaccessible due to money managers’ minimum investment amounts, in the case of a private fund investment, or the high cost of ownership in the case of a direct investment. Private real estate is also less volatile than the public real estate markets as its valuation is not influenced in the short term by market sentiment but rather by the financial metrics and valuation models used by accredited third-party property appraisers to value the private real estate. Over the longer term however, public and private real estate investment returns tend to converge as privately held real estate lags the public REIT market returns.[7]
Besides the four main real estate sub-sectors of office, retail, industrial, and residential, real estate is further subdivided based on its stage of development or perceived riskiness. There are four main risk and return profiles: Core, Core Plus (“Core+”), Value-Add, and Opportunistic. Core real estate generally has a lower expected risk and return profile and is a more conservative investment, whereas at the other end, assets that fall into the Opportunistic profile tend to have a higher expected return and are considered riskier. It is a continuum of risk and return from Core to Opportunistic. In addition, the level of risk is reflected by the debt levels employed. Core real estate usually has higher debt levels (what is referred to as ‘leverage’), whereas opportunistic real estate usually has lower debt levels or leverage. This is because lenders are more likely to lend money on the less risky core real estate and less inclined to lend on opportunistic real estate.
Core real estate assets usually generate consistent net rental income as the properties are newer with fewer capital expenditures required and have a higher tenant quality and occupancy rate. At the other extreme, opportunistic income producing real estate assets, usually have lower occupancy rates (i.e., higher vacancy) and lower net rental income as the properties are undergoing substantial renovation or repositioning – such as converting an office building to a residential complex or demolishing an older industrial building and developing a new industrial building or substantially renovating an existing property for market repositioning. Another example of an Opportunistic asset would be if a property had very few tenants and it needed major improvements. New real estate developments are also examples of Opportunistic real estate. Core+ assets are typically well leased income-producing properties with minimal capital improvement requirements and are occupied, however, by a sub-optimal tenant base. Value-Add real estate includes properties that are income generating but need larger capital improvements and/or a new marketing strategy.
As real estate moves up the risk scale, less of the return comes from net rental income and more comes from capital gains on value creation. Since income is taxed at a higher rate than capital gains, investors seeking capital gains treatment will tend to invest in the riskier Value-Add and Opportunistic risk profiles. Core real estate on the other hand, generally does not create large capital gains upon exit, and so the return stream is more income oriented, which is generally taxed at a higher rate.
It’s clear that the question on whether to invest or not to invest in real estate really comes down to the investor’s risk appetite, the opportunities available, and the type of investment that is presented. Many factors need to be considered in making the best choice for an individual’s portfolio but in the end, it is evident that a well-thought out and researched real estate investment can be a good addition to a well-diversified investment portfolio.
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.
[1] https://www.clarionpartners.com/insights/private-re-investing-macro-uncertainties
[2] https://www.benefitscanada.com/canadian-investment-review/alts/the-evolution-of-alternative-investments/
[3] https://institutional.fidelity.com/app/proxy/content?literatureURL=/9909125.PDF
[4] https://www.cerulli.com/reports/us-high-net-worth-and-ultra-high-net-worth-markets-2022
[5] https://www.alternativesbyft.com/why-commercial-estate
[6] Hines report: “Why Real Estate Now”. Issued February 2024.