As institutional investors increasingly use alternative investment strategies to complement their traditional asset allocations, exposure to real assets and in particular real estate has grown considerably. In a market environment characterized by an advancing business cycle, allocations to high-quality, core real estate can provide a number of important benefits to institutional portfolios.
Introduction
Commercial real estate is a large part of the global investment universe, with an estimated value of USD$59 trillion – an amount nearly equal to the value of global equities by market capitalization. Of this, institutional investors own approximately USD$10.4 trillion globally, of which about USD$2.9 trillion resides in the U.S. and approximately USD$320 billion is in Canada. The vast majority of commercial real estate assets are held in direct allocations (where the property is owned either directly or through a private investment fund), while a smaller portion is held through publicly listed real estate investment vehicles such as Real Estate Investment Trusts (REITs).
It is a sizeable asset class, and over the past two decades, it has become an increasingly important part of institutional portfolios in Canada and globally. Within these growing allocations, core real estate – which focuses on high-quality, income-producing assets in major cities – is typically the largest component of a real estate portfolio, followed by higher-risk, value-add strategies and increasingly, global real estate allocations.1 As an example, Canadian institutional allocations to real estate have grown from 3.7% in 1997 to 12.8% at the end of 2018 (see Figure 2), a more than threefold increase over the past 20 years.
Figure 1: Value of commercial real estate market
All figures in U.S. $trillion. * World Bank, market capitalization of listed domestic companies, December 2018; † LaSalle, Investment Strategy Annual – 2018-2019 Real Estate.
Figure 2: Public pension plan real estate allocations 1997 vs 2018
Source: Pension Investment Association of Canada as at December 31, 2018.
The attributes of domestic core real estate often align well with the strategic objectives of institutional investors and there are compelling reasons to consider allocations to domestic core real estate. These include diversification, low correlation to public markets, operating income with long-term domestic inflation-linked characteristics, the potential for attractive risk-adjusted total returns, potential for income tax synergies, and low relative volatility compared to non-domestic real estate markets. Taken together, these qualities may make core real estate an attractive opportunity worthy of consideration in prudently diversified institutional portfolios.
What is direct real estate?
At its most basic level, real estate is simply a real asset comprising land or buildings, or both. It includes a wide variety of assets, ranging from single-family homes to large mixed-use residential/commercial development projects. Real estate offers investors two sources of potential returns: income flows, which are similar to bond coupons and are mainly generated from rent payments, and capital appreciation, which is sensitive to broader interest rates and income growth.
Investors can gain access to broader real estate in a number of ways; one can choose to invest:
- in debt components (via mortgages);
- indirectly through a real estate company (via REITs); and
- directly through equity ownership of real estate assets.
For the purposes of this discussion, we will focus on direct ownership of commercial real estate, which typically comprises one of five income-producing property types: office, retail, industrial, hotels, and multi-residential buildings.
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