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How Real Estate Can Renovate A Portfolio

By: Eric M. Lerner

What if there were an asset class that rivaled the performance history of equities and bonds? What if that asset class provided low correlation even after adjusting for infrequent valuations? And, what if such an asset class were under-represented in pension fund portfolios? Real estate is the asset class. The question is: With all it’s got going for it, why aren’t pension funds increasing their exposure to real estate? The short answer is investors may (unfairly) regard real estate as a one-trick pony – a reliable hedge against inflation. For others, there may be lingering concerns from a time when real estate – like other asset classes – hit a slump. Finally, some may be put off by the time and expertise required to properly manage real estate.

In fact, real estate (as opposed to REITs) can significantly enhance overall portfolio return potential for a number of very different reasons. Portfolio construction – ensuring the appropriate mix and management of core, value-add, and opportunistic real estate investments – is what can differentiate the ordinary from the truly enhanced real estate portfolio.

The inflation hedge benefits associated with real estate are the result of income flows which are re-priced. For example, in an inflationary environment, costs associated with new construction are ultimately factored into rental rates, ensuring a growing source of income.

Talk Of Inflation
In fact, as talk of inflation continues to escalate, real estate’s hedge benefits alone should be reason enough to increase exposure in a pension portfolio.

But there are additional and compelling reasons beyond the inflation argument to consider, if not increase, real estate allocations. Pension funds that have been holding at a six per cent real estate allocation may find that they can be better served in terms of risk/return benefits by increasing the allocation to 10 per cent or even 15 per cent. To be sure, real estate figures prominently within Canada’s five largest pension funds which hold between eight and 17 per cent. While smaller funds are beginning to see a trend toward higher real estate allocations, there are still some psychological obstacles that may need to be overcome.

For example, liquidity is an oft-cited concern. While it is true that real estate investing requires a long-term commitment, it bears reminding ourselves that pension funds are generally invested for the long-term. In any case, liquidity needs can be easily met by including other asset classes within the pension fund, again driving home the need for a fully-diversified portfolio.

Another question that comes up is whether or not real estate has reached a cyclical high in terms of valuation. It’s a legitimate query as demand for space is a function of economic activity. However, it bears mentioning that the current cap rate compression is consistent with bond yield declines – and we expect cap rates to remain flat for the next year-and-a-half.

If It Walks Like A Stock And Quacks Like A Bond
… then it could be real estate. Real estate offers low correlation to stocks and bonds while at the same time sharing many of the more favourable characteristics found in both. Yet, real estate has some distinctive features which require specific expertise and insight into portfolio construction, management, acquisition, and disposition. Since 1996, the distinctive nature of real estate has proven profitable with returns for the sector outperforming stocks and bonds.

As with other asset classes, real estate can – and, for the purposes of optimal investing, should – be sorted into distinctive categories and risk and return expectations.

Core holdings investments generally offer lower debt levels, low cash-yields, and trophy-like attributes. They can be accessed through direct (segregated) or pooled vehicles. Characteristics include:

With a capital gain focus, value-add real estate investments include properties which require some improvement or enhancement (retro-fitting and change-of-use intended to improve occupancy and leasing rates).

The increased risk assumed should be offset with strong capital gain potential, provided holdings are actively and astutely managed. Hold periods may run between five to 10 years.

At the higher level of the risk/return spectrum, opportunistic real estate investing is all about capital gains. These are the investments that ‘change the character’ of derelict and/or empty properties and renovate them into a fully-leased edifice. These investments require a high degree of expertise in strategy execution for net income improvement and cap rate compression.

Because of the higher risk factor in opportunistic investments, specialized real estate market expertise and execution capabilities are vital in getting the best performance for investors. To maximize the real estate potential in a portfolio, allocations should generally include core holdings complemented by value-added and opportunistic investments. By blending strategies, a real estate portfolio manager can mitigate risk while positioning the real estate portfolio for maximum return potential.

Determining how much real estate is enough should be done in consultation with a real estate investment professional who can ensure portfolio holdings meet the objectives of the pension fund.

What’s In Store?
The individual outlooks for office, industrial, and retail vary. In the office sector, signs point to increased supply tightening. For example, solid high-tech firms that were swept into the fire are rising up from the ashes, and thriving. They need space for their growing cadres of application programmers, game designers, sales and marketing teams, and support staff.

Although tenants are signing shorter lease terms in the industrial sector, they are clamouring for new, state-of-the-art facilities that make good use of land, provide automated distribution, and access to transportation corridors.

In the retail sector, we’re seeing growth in big box stores but, with consumer debt at all time highs, this is an area that requires vigilant monitoring. Over the medium-term, income growth is expected to drive returns even if there is some erosion in capital values. In addition, should inflation increase, and as existing leases expire, rental rates will increase.

From a geographic perspective, western Canada, with its strong natural resourcebased economy, is showing no signs of slowing down, which bodes well for real estate investors, as well. For these reasons, we believe the timing of acquisitions and dispositions of the right investment types is crucial in making the most of these market conditions.

Investing in real estate – literally and figuratively – requires knowing the property from the ground up; what it’s capable of delivering and the people who can make that happen.

REITs: Real Deal Or Shabby Knock-offs?
Others can debate the merits and drawbacks of Income Trusts, but let us be clear – REITs are NOT another way of investing in real estate. One could argue that REITs are the equivalent of a New York Canal Street knock-off. Where true real estate investing is about direct ownership, REITs are bonds dressed up like a building. Like their other income trust brethren, they are vulnerable to supply/demand dynamics and interest rates in ways true real estate investing is not.

The misconceptions associated with real estate seem to prevent many pension funds from making real estate a core part of their portfolio, meaning many investors are missing out on the inherent value-add opportunities associated with the asset class.

Demonstrated strong long-term performance is a – if not the – critical component in investment decisions that applies to both the asset class and the expert you select to manage your real estate portfolio. The need for expertise in this area cannot be overstated as it is that specific insight, combined with due diligence, which distinguishes the best real estate investments from the ones that may not outperform over the longer term. The time has come to give real estate a closer look.

Eric Lerner is vice-president, real estate and infrastructure, at Aurion Capital Management Inc.

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