How to Build a Real Estate Portfolio in a Mature Market
Over the past 20 years, US real estate has outperformed both stocks and bonds.1 While we see several reasons for that trend to continue going forward, we also believe it is important for investors to develop an appropriate framework for their real estate (and overall) portfolio return expectations.
We speak daily with investors about the returns they see on individual real estate offerings, and previously published an article about realistic return expectations for individual deals. But how do investors think about real estate as an asset class? What should they expect from a real estate portfolio? And, how does that feel relative to other asset classes today?
We believe that US real estate has the potential to continue delivering attractive relative returns over the long run. At the same time, we caution investors to moderate their expectations relative to history—both for their real estate allocation and for their broader portfolio.
Building a real estate portfolio: An introduction
Pushing investors to think at a portfolio level can feel like a thankless task. We impress our colleagues at the water cooler with our calls on individual stocks, but it can be much harder to win friends by speaking intelligently on portfolio construction or boasting about the limited correlation of our holdings. There’s an inner day-trader in most of us, and that spirit certainly holds true in real estate.
In our experience, the concept of a well-constructed real estate portfolio is typically an afterthought for most individual investors. We see one-off deals (or funds) and invest in the ones we like. Before we know it, we have a portfolio. Despite our focus at Cadre on identifying what we believe are the most attractive individual opportunities, we would argue that most of the positive attributes of private real estate come from owning a solid portfolio rather than a well-selected deal.
The question we will tackle here is: How should an investor think about building a “good” real estate portfolio? And, what exactly does “good” mean in the context of an economic cycle that, if not yet gray in the beard, is definitely sporting a salt and pepper look?
There are a few consistent refrains we hear from institutional and individual investors alike:
“I like real estate in my portfolio because it provides inflation protection.”
“I like earning tax-efficient cash yield.”
“Private real estate isn’t highly correlated with the stock market.”
These are all good reasons for investing in real estate, but they are difficult for investors—especially individuals—to actually implement in a diversified way. Traditionally, this requires a fair amount of capital, or is only partially achievable through funds or REITs. Even for larger investors, portfolio-level performance can suffer due to high fee leakage or inflexible allocation decisions.
To further complicate things, real estate managers often talk about making sector and/or geographic bets, but rarely clarify which aspect matters more. Is an asset in a sector that’s facing headwinds (e.g., retail) but located in a positive-momentum market (e.g., Seattle) a better bet than owning an Amazon-leased warehouse in a market like Omaha?
Here, we provide a simple framework to help investors build an effective real estate portfolio using a few basic insights.
Three questions to ask while building a real estate portfolio
1. What level of return should I expect from a well-balanced real estate portfolio?
Without a response to this question, investors take three risks:
- Acting on unrealistic expectations
- Insufficiently assessing the risks they’re taking
- Over- or under-allocating to real estate relative to other asset classes
Thankfully, the institutional real estate community has tackled the return question by creating a number of public and private sector benchmarks. The most prominent are published by NCREIF (which tracks private real estate returns) and NAREIT (which tracks public REIT returns).
As with all publicly traded stocks and bonds, public REIT performance is readily available and analyzable. However, private real estate suffers from the same transparency and measurement issues as other “alternative” asset classes (private equity, venture capital, etc). For example, volatility—and therefore risk-adjusted returns—is difficult to measure. Notwithstanding their shortcomings, these indexes are a useful guide for investors looking to “level-set” their their return expectations for the asset class.
To this point, the Pension Real Estate Association (PREA), an organization that represents the interests of some the largest U.S. institutional real estate investors, publishes a quarterly forecast of what its members think the NCREIF NPI index will return, by sector, over the next five years. In the Q4 2018 PREA quarterly survey, respondents on average expected unlevered U.S. real estate returns (i.e. before using debt) to average 5.4% per year through 2023.2 This five-year outlook is the PREA survey’s most publicized metric, but there are other data points in each survey that are worth understanding, such as the forecast for the upcoming year, property type-specific forecasts, and an evaluation of how the forecasts have evolved over time.
These forecasts are only projections, but we still find them directionally instructive as a guide for answering this first key question. Here’s a concrete application: Let’s say we’re comfortable as a private investor using 50-70% leverage (as we typically do at Cadre) at an average cost of say 4-4.5%. This takes our projected baseline return as an equity investor from 5.4% to more like 7-8%. Assuming we can pick better than average assets and markets, execute on a value-add investment strategy, and exit opportunistically, we may further boost that portfolio return expectation to 9-10%. Not bad on a relative basis (as we will soon show), but also not 20%+ returns as we still hear from even many sophisticated investors as it relates to their private real estate expectations.
2. How do real estate returns compare with other options for my portfolio, like stocks and bonds?
We find it instructive that the same institutions that help set this PREA return forecast are on average targeting an increase in their private real estate allocations going forward.3 Simply put, they believe real estate offers attractive value relative to their other options.
Let’s examine those other options in a bit more detail: There is not an “industry-standard” forecast for public equities and debt. And we have yet to come across anyone that credibly predicts the S&P 500 on an annual basis. But we do pay attention to a handful of organizations that focus on intelligently assessing long-term return potential. As an example, the investment manager GMO has long published “7-Year Asset Class Real Return Forecasts” which they update quarterly. As of Q3 2018,4 they projected the 7-year real return for US large cap equities as -5.2%. Assuming 3% inflation, that gets you to a still very underwhelming -2.2% nominal forecast. And US bonds don’t fare much better, with a 7-year forecasted real return of zero. According to GMO, the best projected performer is Emerging Market equities, at 3.2% real (~6.2% before adjusting for inflation).
Short term, we don’t claim to be able to predict returns in real estate, let alone the broader market. But we do believe in the relative appeal of real estate over the long run. The opinions and actions of several respected players seem to support that view.
3. How do I achieve real estate exposure the “right” way?
The final question is “now what?” How can I reconcile the “good” (portfolio enhancement) with the “bad” (tempered outlook for returns) while avoiding the “ugly” (loss of capital)? We suggest following these three guidelines:
- Diversify your bets. A series of small sector bets is more likely to achieve your portfolio objectives than a single concentrated investment. Interestingly, a well-respected study found that real estate diversification is more easily achieved through investing in multiple property types (as opposed to multiple geographies). The study’s other interesting finding was that investors need exposure to more than just a few properties in order to effectively achieve diversification. So while you may not need to own hundreds of buildings outright, you do need to own at least several small increments of real estate to achieve the desired effect of a diversified portfolio.
- Take a view on property types or invest with a manager that does. The study referenced above also implies that taking the right view on a specific property type can materially affect performance vs. the overall market. We even observe varying degrees of return potential within specific property sectors. For example, an analysis of NCREIF apartment sector returns show that for the apartment sector, total returns on older properties (20+ years old) have fared better than those on newer properties since 2014.5 Investors who chose to overweight their portfolio during that time in vintage vs. new-build apartments would have therefore been more likely to see outperformance.
- Choose the right vehicle for accessing real estate. Achieving the full benefits of diversified real estate requires more than creating a building collection—it requires creating a dynamic building portfolio. Return potential for certain properties and geographies changes over time, as does the overall size and complexion of an investor’s portfolio. Ideally, investors have the ability to adjust their real estate portfolios more frequently than buying or selling a small number of one-off buildings every several years.
Most informed investors today agree that real estate can be an attractive way to enhance the risk and return profile of their portfolio, but the next step is less clear: How do I effectively build real estate exposure?
At Cadre, we’ve dedicated our efforts to providing a better option: Access to institutional quality private real estate that allows for attractive relative return potential, diversification, tax efficiency, and liquidity optionality without the volatility of public markets. Our experienced team and data-driven approach are geared toward making informed bets on specific sectors and geographies in order to achieve returns above the industry average. To learn more about building your real estate portfolio or to become an investor, please request access to the Cadre platform.
- “Invest in the asset class that has outperformed the S&P 500 over the last 20 years” refers to the cumulative return (with full reinvestment of dividends) of an investment in the FTSE NAREIT US Real Estate Equity REITs index as compared to investment in the S&P 500 (using S&P Total Return data from CBOE) for the period from December 2000 – December 2018. Investments with Cadre are in private real estate interests and are materially different from investment in US equity REITs; real estate return data should not be used to estimate the return of Cadre investments.
- Source: prea.org
- Source: NREI. https://www.nreionline.com/investment/institutional-investors-plan-come-back-targeting-core-cre-new-intention s-survey-shows
- Source: https://www.advisorperspectives.com/commentaries/2018/10/23/gmos-7-year-asset-class-forecasts-still-favor-e merging-markets-over-u-s-stocks