April 10, 2023
Investment Strategy Brief: Getting Real About Real Estate
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Below is a transcript of this week’s video:
We have heard a growing number of questions about real estate at the start of this year and figured it is likely a good time to check back in and remind everyone of our thought process on this part of investors’ portfolios. Doing this will hopefully dispel some misconceptions and substantiate the investment opportunity, while also recognize that some risks realistically exist.
From a 40,000-foot view, commercial real estate as an asset class is larger than many investors recognize, constituting more than $20 trillion in aggregate market value in the U.S., about half the size of all U.S. public stocks. However, real estate investment trusts (REITs) — public companies that own and operate commercial real estate — account for only 3% of the public markets. Such structurally underrepresentation, of course, is a function of real estate being more commonly owned directly or through private investment vehicles rather than through registered investment vehicles or securities.
However, investors should try to push through these artificial barriers to see the true opportunity. Since 2001, broken down by price appreciation and income, real estate offers the opportunity of equity-sized returns with more of the return coming from income than other equities. Looking at correlations between major asset classes, including real estate, should help one see the opportunity for diversification given the low correlations. As a result, real estate can be a key component of a diversified allocation that enhances a portfolio’s risk-adjusted returns and should be a consideration for most investors.
Real estate, REITs in particular, had a difficult year last year as the performance of publicly listed real estate followed its historic tendency to reprice alongside other equity investments in risk-off periods. Further, it again showed that it is particularly sensitive to interest rates volatility, underperforming broader equities as rates rose rapidly in 2022.
Of course, this poor performance has left real estate at more attractive valuations than broader equities, whether one looks at U.S. REITs or Global Real Estate. And with rate hikes nearing their ending point, it is possible to see a situation where rate volatility subsides, and real estate can move past the interest rate concerns.
Another concern that we often hear surround the demise of the office and retail real estate with the COVID-induced shift toward hybrid work and online ordering. Now, while we are empathetic to this leading to reduced demand for office real estate and have our own proclivity to click-and-buy, we think there are multiple other dimensions of this story. First, vacancies data currently shows that difficulties are most apparent in office properties, but those issues are not representative of other real estate sectors, even retail, which are performing relatively well. In fact, of the major REIT groups, office is the only one to feature an increasing vacancy rate since the start of the pandemic.
Another dimension is the constantly changing nature of real estate. Many of us think about real estate as largely being offices and retail stores, but the use of real estate has shifted. While offices and retail properties did constitute almost half of the REIT market before the Great Financial Crisis, they now account for less than 14% of the publicly owned real estate. By contrast, ever-growing demand for residential and industrial space has maintained its share, while the alternative category, which includes cell tower, data centers, healthcare and storage, has doubled in size. In short, real estate is limited in supply and can be repurposed to other uses, albeit with some conversion costs.
Of course, this does not mean that real estate is without risk. Unlike cash or Treasuries, its associated income is not close to risk-free. Every property needs paying tenants and both demand and ability to pay ebb and flow with the economic cycle. Further, shifting ownership of properties and the ability to trade and upgrade are limited by the availability of commercial lending, which with recent banking troubles is entering a tough patch. We will continue to monitor the impact of these factors.
Lastly, back to the ownership options for real estate, some of our clients will have sufficient size and liquidity to consider private real estate investment instead of public. However, last year, publicly traded REITs underperformed their private counterparts by double digits. Historically, such large periods of underperformance are followed by a reversion to the mean in which the pendulum swings the other direction, and the laggard outperforms. As a result, investors should have a marginal preference for public REITs in the current environment.
- Misconceptions about real estate provide opportunities for investors seeking equity-like returns and portfolio diversification.
- Interest rate sensitivity, in part, has driven real estate to a discount to fair value but recent rate hikes may now be nearing an end.
- Growing vacancies in office properties are apparent, but those issues are not representative of broader real estate, which is doing relatively well.
- Real estate, however, is not without risk; like other risk assets, it is sensitive to the economic cycle and associated changes in lending availability.
- Investors should maintain a healthy allocation to real estate in their portfolios, currently with a preference for public REITs.
This material is intended to review matters of possible interest to Glenmede Trust Company clients and friends and is not intended as personalized investment advice. When provided to a client, advice is based on the client’s unique circumstances and may differ substantially from any general recommendations, suggestions or other considerations included in this material. Any opinions, recommendations, expectations or projections herein are based on information available at the time of publication and may change thereafter. Information obtained from third-party sources is assumed to be reliable but may not be independently verified, and the accuracy thereof is not guaranteed. Outcomes (including performance) may differ materially from any expectations and projections noted herein due to various risks and uncertainties. Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss any matter discussed herein with their Glenmede representative.