As alternative asset classes continue to be a major area of interest for institutional investors, considering the benefits and drawbacks of real estate as an allocation is an important exercise. In Canada, real estate, particularly residential, in core metropolitan areas has been an area of major investor and media interest as property values have skyrocketed. However, considering an allocation to real estate requires peeling back a few layers to achieve greater context.
The real estate opportunity set
Real estate investment is generally considered attractive due to diversification benefits when combined with traditional asset classes, high cash flow yields and high returns, particularly when aided by leverage.
The various approaches to real estate investment can be characterized similarly to the infrastructure investing approaches highlighted in one of my previous expert columns. Real estate investment uses either an unlisted or listed approach and individual properties can be classified as either core, value-added or opportunistic.
Unlisted real estate approaches include open-end, perpetual funds as well as closed-end funds with definite liquidation dates. These funds may feature significant leverage and fees are generally high, though there are skilled managers in this space with the ability to add value with active management and improvement of properties.
Listed approaches include real estate investment trusts and real estate operating company investments. These securities trade on public exchanges. This public market liquidity, coupled with lower minimum investment requirements for listed real estate, means that this approach may be most appropriate for smaller institutions looking to allocate to the asset class. This said, the diversification proposition of listed real estate is weaker, with listed real estate companies bearing higher correlation to broad equity markets.
Core, value-added and opportunistic approaches differ in their complexity, type of underlying property, and composition of returns. Core approaches will most often feature major property types (office, apartment, etc.) with low to moderate leverage and investor returns primarily consisting of income yield. Value-added real estate features more specialized properties such as hospitality and assisted care with moderate leverage and more return coming from capital appreciation. And, opportunistic approaches often use higher leverage and have a significant expected return from property capital appreciation. Speculative and undeveloped projects are more commonplace in this subsegment.
Importantly, return dispersion of managers in the value-added and opportunistic segments are significantly higher than in core real estate, meaning that these more complex approaches should likely only be sought by organizations with the ability to either perform or outsource appropriate manager due diligence.
Benchmarking and appraisal issues
Institutional real estate benchmarking will often recognize the absolute-return focus of these allocations by using an fixed or inflation-plus absolute return benchmark, such as the consumer price index plus four per cent on an annualized basis. Additionally, the use of total return-based composite indexes of global real estate funds is common.
It is important to note, unlisted real estate shares a feature with other widely alternative asset classes such as private equity and infrastructure: smoothed performance. Net asset values of unlisted real estate funds are generally calculated quarterly and are appraisal-based. The inherent subjectivity of real estate appraisal and the infrequency of reporting cause unlisted real estate to show lower volatility as well as lower correlation with other asset classes. Though the return potential of real estate can merit an allocation, artificially suppressed volatility and correlation caused by smoothed pricing should not be a main driver behind the decision to allocate to the asset class. Unsmoothing (adjusting smoothed prices to more accurately reflect the underlying asset performance) can provide some insight into the true risk of illiquid strategies like unlisted real estate.
An institutional allocation to REITs and REOCs may also be benchmarked to an absolute-return target, though composite benchmarks can be more useful for these strategies. As mentioned, REITs and REOCs are much more similar to public equities and a similar benchmarking approach can be appropriate.
Also, certain index providers have the ability to provide custom benchmarks based on the underlying exposures of an institution’s real estate allocation, such as geography and style. This type of approach may be appropriate for larger institutions with dedicated direct real estate allocations.
As is the case with other alternative asset classes, relative allocations by institutional investors to real estate have been increasing and this is expected to continue. Increased demand, along with a confluence of other factors, such as a generational low in bond yields, have driven real estate capitalization rates (the net operating income of a real estate investment divided by the value of the real estate and thus a valuation proxy) and expected returns lower. Yet, the relative attractiveness of the asset class versus others may not necessarily be worse than at other times in recent history. For example, in the United States, the cap rate spread (cap rate less the 10-year US treasury yield) was near its long-term average of 2.8 per cent in late 2019. And, as cap rates have moved lower, expected returns on many other asset classes have descended with them.
Overall, the value proposition of real estate investing is compelling. That said, the concerns in the unlisted space are similar to other alternative investments: illiquidity, cost and complexity are high so having the appropriate time horizon and due diligence platform are important for achieving success. For smaller institutions, many of the benefits of an unlisted approach may be achieved via more transparent and cost-effective listed strategies.
As always, some introspection and self-assessment will help guide an investing institution in the right direction.