Diversification: A Key to Playing the Global Real Estate Recovery
Key Takeaways:
- Why real estate? It can improve risk-adjusted returns for a traditional stock-and-bond portfolio.
- Why real estate now? The steep reset in valuations over the last 24 months, coupled with solid fundamentals and a benign macro environment, creates an attractive entry point.
- Why diversified real estate? Investing across geographies, the capital stack and vintages can improve a real estate portfolio’s risk-adjusted returns. Real estate is a cyclical asset class anchored to interest rates and economic activity, but performance in the current down cycle has varied significantly based on property type, region, and portfolio construction. We believe departure from near-zero interest rate policy paves the way for further dispersion across returns in risk assets going forward.
- What’s the best way to diversify? Identify multiple themes that are likely to enjoy the most resilient supply-and-demand dynamics and express those themes through different geographies, product types, and across the capital stack.
- Transactions on the rise: Global deal activity is picking up, and our investment pipeline is more active than ever before. Scaled, well-capitalized investors may be best positioned to play the recovery.
The current real estate down cycle is the second deepest since World War II, with prices across all types of U.S. commercial properties down 22% on average from their peak. It is also one of the more enduring downturns—two years strong and still going, while it took only 1.7 years on average for the market to bottom in the downturns of the last 50 years (Exhibit 1). The tide is shifting, though, revealing interesting investment opportunities all over the world.
EXHIBIT 1: Historical Peak-to-Trough Real Estate Declines
Our view is that the beta trade is over. Low interest rates no longer serve as an anchor for values on risk assets, and what worked in the last decade may not work in the next. As performance dispersion increases, a thematic approach across diversified exposures will become more important.
Diversifying with Real Estate and within Real Estate
Real estate has long been an important diversifier for traditional stock-and-bond portfolios, but a global allocation has additional benefits. Adding broad exposure to real estate1 would have historically reduced the volatility of a portfolio of stocks and bonds such that investors could have achieved the same returns for lower levels of risk (Exhibit 2). The effect was even more pronounced when the real estate allocation was diversified by region. Investing in U.S. real estate equity and credit would have resulted in the highest absolute returns over the last 10 years, but adding assets from Asia and Europe would have resulted in higher risk-adjusted returns (Exhibit 3).
EXHIBIT 2: Adding Real Estate to a Portfolio Allows for Same Returns at Lower Risk
EXHIBIT 3: Performance over 10-Year Period
Going global is more important now than ever. With the disappearance of global zero-interest (or negative-interest) rate policy, central banks have gotten out of the business of anchoring asset values. We think this is driving stronger dispersion than years past in how assets perform by region, theme, and other characteristics. Specifically, we think that U.S. performance may not dominate the rest of the world to the same degree as in the past, now that rates are no longer in the zero-bound and supply-and-demand dynamics are shifting in some sectors.
To understand how we approach relative value across the globe, it’s important to understand differences across regions in the three factors that drive differences in real estate returns (Exhibit 4).
EXHIBIT 4: Three Key Drivers of Real Estate Returns
Understanding How 3 Drivers of Returns Play into Global Allocations
Macroeconomic Conditions
Economic growth, fiscal policy, inflation, and interest rates can have direct effects on real estate returns.
Broadly speaking, the United States, Europe, United Kingdom, and some Asia Pacific markets such as Australia have been moving in lockstep for the last few years. Higher inflation and elevated interest rates challenged real estate investments, prompting significant resets in valuations and a slowdown in transactions. Key differences between United States and Europe, however, are the absolute level of interest rates and the timing of future rate cuts, as evidenced by the European Central Bank’s June 2024 rate cut, as well as the pace of adjustment. Unlike in the Global Financial Crisis, Europe has been ahead of the United States in turns of property owners taking writedowns. Our house view is that GDP growth will be slower in Europe than in the United States, but that lower overall rates should better anchor valuations going forward and a recovery may occur faster than in the United States.
Asia Pacific economies, for the most part, did not experience the dramatic and detrimental inflation and interest rate changes Western economies did (Exhibit 5). Japan is experiencing inflation for the first time in several decades, but the environment remains supportive for real estate investments. The Bank of Japan raised rates from essentially zero (0-0.1%) to 0.25% in July. We think real estate markets should be able to absorb this rate hike, particularly since they coincide with improving rent growth in an inflationary environment.
EXHIBIT 5: Interest Rates Around the World
Fundamental Supply-and-Demand Conditions
In addition to the macro backdrop, the balance between supply and demand in specific sectors and regions is a potent driver of returns. When evaluating fundamentals, we seek to identify themes that are likely to have resilient long-term demand—themes like senior housing at a time when global populations are aging or hospitality in tourist centers such as Europe and Japan—and juxtapose that with supply dynamics.
The office sector illustrates how themes can play out differently across regions. Employees returned to the office quickly in Asia Pacific, encouraged by relatively fast commutes, relatively small living spaces, and cultures that place a high value on in-person work. In the United States, where suburban employees often face long commutes and have larger living spaces, working from home has been much more entrenched. Office vacancy rates reflect the trend (Exhibit 6): South Korea, for example, has the tightest office market in the world, with only 1% vacancy. In both Europe and the United States, there is also a sharp bifurcation between the newest office buildings with the most amenities and in the best neighborhoods and…just about everything else. In summary, the challenges of the office sector have dominated headlines, but in select international markets, fundamentals are robust.
EXHIBIT 6: Office Vacancy Rates Vary Significantly by Region
Capital Considerations
Recapitalization is driving much of the movement in real estate today. The availability and cost of capital has been a major consideration in how real estate markets function in the United States and Europe over the past three years. Equity and debt capital availability has shifted due to regulatory, portfolio management, liquidity, investor redemption, and other considerations. The result is a profound opportunity for investors across debt and equity.
In the United States, banks account for some 50% of commercial real estate lending and have pulled back dramatically on lending due to regulatory pressure and challenges with existing real estate loans, particularly in the office sector. While insurance companies and non-bank lenders have been more active, they are not large enough to make up for the gap in real estate funding.
Lenders have been able to earn double-digit returns and double-digit yields in the junior tranches of first mortgage risk. Non-traditional lenders such as hedge funds and other private capital have entered the market as a result, and since the beginning of the year, we have seen real estate credit spreads tighten. However, we still see attractive absolute returns available in real estate credit overall.
Transactions, Transactions, Transactions
The real estate equity markets in both Europe and the United States are at a critical turning point. With many equity owners under growing pressure to sell assets, we are seeing more opportunities to buy high-quality assets in sectors with strong fundamentals at attractive valuations. While a significant gap between what sellers were willing to accept and buyers willing to pay for property kept transaction volumes muted for the last two years, we are seeing that gap narrow as sellers become more realistic and motivated to sell at the same time as financing markets are allowing buyers to improve their bids.
Our own pipeline reflects the shift: In the first six months of 2024, we have closed on or contracted $12 billion in real estate transactions all over the world. In the United States and Europe, we are seeing recapitalization needs leading directly to transactions, including with REITs selling assets to gain liquidity and open-ended funds managing redemption and liquidity needs by selling property. In Japan, shareholder activism is pushing publicly traded companies to identify ways to increase returns, leading to many corporate behemoths selling off large real estate holdings that are not core to their business. The common thread: transactions borne of pressure on owners to free up capital for other uses. Investors with multiple, flexible pools of scaled capital are likely best positioned to take advantage of the opportunities we are seeing today, which occur around the globe and throughout the capital stack.
Conclusion
Both our quantitative research and our experience suggests that investors who take concentrated risk in a specific market, theme, or even invest too heavily during a particular period of time may not be maximizing their long-term risk-adjusted return potential. If the past few years have taught us anything, it is that concentrating in an asset class or with direct exposure to a set of individual assets can leave investors vulnerable to unforeseen challenges related to macro conditions, fundamentals, or liquidity. In our view, going global, investing in both equity and credit, concentrating on themes with solid long-term fundamentals, and maintaining a disciplined approach to investment over time is a better way to look for value in the asset class than taking highly concentrated bets.
1 Including global public REITs, private real estate equity, and private real estate debt
