Navigating turbulent times - Real estate portfolio construction and risk management during a downturn

The COVID-19 public health crisis and the ensuing, severe economic recession have catapulted risk and how to manage it to the forefront of institutional investors’ minds.

In this environment, in which elevated uncertainty is combined with record-high prices of financial assets, real estate appears to represent an important asset class for institutional investors. How should investors construct their portfolios and manage risk when the future is highly uncertain and markets are volatile?

Leverage the benefits of diversification - It is often observed that in a crisis, all correlations go to one, but there is a wide divergence in both the magnitude, timing of declines across markets and property types, and the pace at which they recover from a downturn. For example, industrial and logistics properties in the US, UK and Europe have fully recovered after declining slightly in early 2020 and even exceeded their pre-pandemic peaks by the end of the year. In contrast, hotels had fallen in value by 20% to 30% by the end of 2020, with the potential to continue to fall further in 2021. Aspects of diversification provide two important implications for portfolio construction. First, having a balanced and diversified approach to exposure as a starting point can lead to less volatile valuation impacts through a downturn. Second, focusing on markets that are recovering most strongly from the current downturn can result in outperformance.

Be conscious of the impact of home bias - Home bias is often one of the largest fault lines of risk within an institution’s commercial real estate portfolio but is given the least attention when thinking through managing risk through portfolio construction. Cross-border investments are viewed primarily in relation to the impact they will have on the returns of the institution’s commercial real estate portfolio, rather than the impact they will have on the portfolio’s risk profile. The low-hanging fruit for investors investing outside their home markets, in countries with very different economic drivers. During and immediately after a downturn can be an opportune time for an institution to grow its global real estate portfolio and increase the benefits of diversifying across markets as valuations are typically lower and lower competition looking for attractive investment opportunities.

Look to the public markets for clues and opportunities - Changes in listed real estate valuations can provide valuable insights as they trads daily, allowing for new information to rapidly be incorporated into share prices. A clear example of this divergence came in the second half of 2020, when REITs focused on office properties in major city centres traded at significant discounts — in excess of 20% — to their estimated private-market value, while industrial REITs, which own distribution warehouses that service ecommerce retailers, traded at premiums to private-market value with below-market yields. Historically, private real estate markets have lagged listed equity markets by approximately six to nine months. It is however important to note that public real estate markets can overstate the scale of impact and, as a result, be more volatile than the eventual out-turn in private real estate values.

Look through the short-term noise to find the long-term signals - In today’s world of an overwhelming volume of information, it is critical for investors to focus on the changes that are likely to affect the long-term drivers of commercial real estate performance, rather than the short-term shifts resulting from peoples’ reactions to the pandemic. One example is the critical role barriers to entry of new supply have in driving long-term rental growth. The demand for office space post-pandemic may be higher in suburban locations or smaller cities than in large, dense cities. But the planning and zoning system is typically more supportive of new development, the cost of new construction is lower, and the availability of land in those locations is much higher. This means that while incremental demand may lead to some growth in rents in the short run, developers can more easily and quickly respond by increasing the supply of space, resulting in limited growth in rents over the long term.

Stick to the plan - Big swings in markets and commercial property prices seem to instinctively call for a response that is commensurate in scale. This could come in the form of revising an institution’s investment strategy, strategic asset allocation, or changing portfolio allocation to property types, geographies or managers. Another common response is putting all new investments “on hold” and waiting for markets to “bottom” or become more stable before returning to the market. Holding through the cycle is an obvious concept but hard to implement in periods where investments are suffering. Harder still is continuing to make new investments through the cycle, which is critical, especially for growing pension and sovereign wealth funds.

Keep calm, carry on and embrace opportunity - The world’s cities have survived plagues, wars and natural disasters, and this challenge, too, shall pass. As the next real estate cycle begins, institutions that have a solid bedrock of considered portfolio construction and risk management to base their investment strategy upon will be well positioned to make investments that will benefit their stakeholders for years and decades to come.

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Published on Institutional Real Estate, Inc (IREI), Jan 2021

Navigating turbulent times - Real estate portfolio construction and risk management during a downturn

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