Why Investors need to reconsider their approach to real estate allocations

Institutional investors will need to reconsider their approach to real estate allocations and build more active and more flexible investment programmes in order to achieve their long-term objectives from the asset class. Several trends, both structural and market related, will drive this need and investors should think hard about the implications it might have on their existing and planned portfolios. 

The end of long and short 'beta' 

Both the 'long beta' and 'short beta' effects have played out or at least have significantly faded as a contributing component to future returns. In terms of 'long beta', benchmark yields globally have fallen from a level of around 15% in early 80's to barely positive and more recently negative across maturities. This is certainly not the only factor affecting returns but has been an important one with meaningful impact on pricing, values and ultimately historically realized returns. In terms of 'short beta', returns in the post-GFC period, capital value growth has predominantly been due to asset repricing as a direct result of increased liquidity and stimulus programs globally with relatively limited contribution from fundamental demand factors. Unless one expects this to continue there is no particular reason to expect asset values to perform as they have post-GFC. Does this mean that real estate is becoming less attractive? Certainly not, it is one of the most attractive asset classes, both fundamentally and even more so from a relative value perspective, generating a majority of total returns from income. But it does highlight that as allocations increase, investors should take care in simply interpolating historical performance over any time period when forming objectives and expectations about future outcomes. They should spend time focusing on more granular components that make up total returns and assign expectations to those.  

Market divergence and the need to focus on intrinsic market cycles 

Taking Europe as an example, the aim for the region has long been to 'synchronize' the various economies and bring them, as much as possible, into the same growth cycle which allows for more efficient fiscal and monetary policy implementation. As real estate is largely dependent on economic activity and growth, it has meant that real estate cycles across Europe have also been 'synchronizing' over the past couple of decades or so. A general Europe-encompassing allocation might have made a lot of sense in the past, however might not be an obvious choice going forward. Structural long-term growth prospects are very different across the region and will continue to diverge which will lead to more 'de-synchronized' growth paths, real estate cycles and ultimately performance. Making a distinction between structural factors with focus on intrinsic values and cycle dynamics from the 'noise' included in short-term returns will be increasingly important for building successful long-term portfolios. Investors will need to move away from a general approach to a more fine-tuned and develop analytical approaches to better understand and predict intrinsic values of individual markets, see e.g. RECI structural real estate cycle indicators. As divergence in market returns is likely to increase, a general approach will also create a drag in investment outcomes.

Growth of allocation options will drive sophistication and lead to more active programs

Real estate allocations have traditionally been relatively boring and predominantly structured around core, value-add and opportunistic, listed equities and maybe some debt products. Today there is a wider opportunity set of actionable allocation options which are also increasingly being incorporated into investment programs. In private markets these include e.g. CRE private debt across the capital structure from senior to mezzanine. In listed markets, there is an ever growing range of indexing products/ETFs and within those separate factors targeting specific return profiles, characteristics and sources. These new allocation options will need to become a natural part of the investment process and investors will need to gain detailed understanding of both opportunities and risks associated with each, but in return will have much better tools to enable them to design and implement more unique exposures as well as manage those exposures more actively and efficiently.

Building better real estate allocations 

At the same time, investment flows and institutional allocations keep rising with target portfolio levels at around 10%. Estimates show that each 1% allocation increase implies ca USD 150Bn in additional investment demand. These inflows will continue to make a positive market impact, but in order to build successful portfolios going forward investors will have to change their approach and take a fully holistic view of real estate as an asset class incorporating the many dimensions and unique exposures it has to offer. It will be necessary to consider specific market cycles and trends in greater detail, be able and willing to take a more active approach and to utilize new options to a greater extent to achieve target outcomes. Investments across the entire continuum of capital structure, product range and liquidity will be necessary to realize the full potential of this most fundamental asset class.

General and boring no more. Welcome to the new age of real estate allocations where sophistication, flexibility, timing and an active approach will create the necessary edge to achieve positive investment outcomes. 

Witold Witkiewicz, Kania Advisors