Real estate has long been seen as a rich hunting ground for investment returns by institutional and individual investors alike.


Sophisticated institutional investors such as sovereign wealth funds typically adopt a systematic asset allocation approach that explicitly aims to take advantage of the potential diversification benefits of including real estate in a multi-asset portfolio.


By contrast, individual investors often view real estate investments separately from their holdings of stocks, bonds and cash.


Such investors are likely to benefit from a deeper understanding of the role that real estate can play as part of a broader investment portfolio.


Why invest in real estate at all?


* Diversification


Multiple studies have shown that real estate returns display a low correlation with returns on listed equities or bonds. This means that adding real estate to a portfolio comprising mainly equities and bonds can help reduce the total portfolio risk, potentially enhancing its risk-adjusted returns.


Real estate assets are typically priced on a local basis and the performance of individual properties is heavily influenced by local supply and demand dynamics and regulations.


Even within a single country, local drivers of real estate returns are likely to vary across different locations and property types such as office, retail, industrial and residential. This means that adding a large number of properties across multiple locations and property types to a portfolio of equities and bonds can offer a double or triple diversification benefit.


The evidence is strongest for private or unlisted real estate, although several studies have concluded that it is beneficial to add both private and listed real estate investments to a portfolio, according to a 2015 review of academic studies since the early 1980s by Norway’s sovereign wealth fund.


* Inflation hedging


Real estate returns tend to be more closely correlated with inflation over time compared with equities or bonds, especially when inflation is accelerating.


A key reason is that real estate leases typically adjust to reflect changes in inflation, especially for commercial property such as office space, while property prices tend to rise with the cost of construction, which increases with inflation. This means that adding real estate to a mixed-asset portfolio can provide a valuable inflation hedge for investors seeking to preserve their purchasing power, especially when inflation is accelerating.


* Stable income, with the right asset mix


Income from rentals typically contributes a large proportion of global real estate returns.


A skillfully constructed real estate portfolio comprising multiple high-quality properties with long term leases that expire at different times can offer a rental income stream that is relatively stable even through short term market ups and downs.


Sophisticated investors have long sought to reap these benefits


As at July 2018, there were 499 institutional investors worldwide allocating US$1 billion or more to real estate, led by the Abu Dhabi Investment Authority with US$62 billion, according to alternative-asset data provider Preqin.


Other sophisticated asset managers also explicitly allocate part of their portfolios to real estate to harvest the associated benefits.


“We invest in real estate to improve the fund’s risk-return profile and to achieve a more diversified portfolio,” Norway’s Government Pension Fund Global states in a March 2018 report. “We expect real estate investments to have a different return profile to equities and bonds in both the short and the longer term,” the fund stated in its 2017 annual report.


What about the risks?


Private real estate investments are typically bulky and illiquid. Investors must be prepared to weather extended periods of very low liquidity when assets are difficult to sell, especially in market downturns.


Rising interest rates are widely seen as negative for real estate investments, as higher rates reduce the investments’ present value and the relative appeal of rental income streams.


Research shows a close link between real or inflation-adjusted interest rates and the returns on real estate, which tend to decline when real interest rates are rising.


Overall, the relationship between interest rates and real estate returns and values is a complex one. Policy rate hikes typically take place when economic growth is strong, as was the case in the US.


Against this backdrop, rising interest rates tend to be associated with higher rents due to inflationary pressures, while risks such as tenant defaults and development risk would likely decline. In the longer run, other factors such as increased supply of real estate in response to higher demand would come into play.


Distributing a real estate portfolio widely across different locations and property types helps to reduce the potential impact of these and other risks, including natural disasters and terrorist attacks, regulatory and political risks, and risks associated with a particular property.


This can be achieved by assembling a large real estate portfolio comprising many properties, or gaining exposure to such a portfolio through investment vehicles such as real estate investment trusts and unlisted funds.


Investment in global real estate also entails currency risk which is a more material part of the investment risk due to the stability of the underlying returns.


Adding real estate to a mixed-asset portfolio offers key diversification and inflation hedging benefits, potentially enhancing the portfolio’s risk-adjusted returns.


With the right asset mix, a skilfully constructed real estate portfolio can also offer an income stream that is relatively stable through market ups and downs.


Adapted from: The Business Times, 12 January 2019