Too much emphasis on geographic and sector diversification within real estate portfolios can hinder alpha generation. More focus on lease length, asset quality and other factors is a preferred means of reducing specific risks whilst allowing specialisation, argues Tim Perry.
The location and sector of a building are its most defining physical features. This, along with the accessibility of data on both, has led geography and sector to become the default ways of categorising properties and assessing the diversification of real estate portfolios. However, an excessive focus on diversification by these measures is misplaced, and can result in sub-optimal investment outcomes. Investors can better manage portfolio risk by considering a broader range of real estate characteristics.
To begin with, sector and geography do not have as much influence as one might imagine in explaining variations in asset performance. As Figure 1 illustrates, UK real estate markets segmented by geography and sector tend to move in a highly correlated manner. According to analysis by MSCI on a global selection of real estate funds, sub-market allocation represented just 30 per cent of the tracking error of real estate portfolios relative to their benchmarks between 2008 and 2019.1 The rest was down to other factors.
Figure 1: Rolling 12-month total returns of UK real estate segments (per cent)
Figure 2: Correlation of quarterly total returns of UK regional office markets, 2001-2020
Meanwhile, Figure 2 shows the high correlation between the returns of different regional office markets over the past two decades, revealing that a diverse allocation across these markets would have provided little benefit to portfolio volatility.
Too much focus on sector and geography means other, equally important, sources of diversification are underappreciated, such as tenant exposure, asset quality and timing of lease events. Furthermore, a disproportionate focus on sector and geography discourages the concentration of resources to nurture deeper, and more valuable, expertise. One of the main reasons real estate has strong alpha-generating potential is because it is possible to develop informational advantages, for example on a local market or specific niche. Excessive diversification restricts investors’ ability to exploit such advantages.
We previously argued diversification can be achieved in real estate with a relatively small number of assets2; similarly, it is possible to attain this without spreading investments across a wide range of sectors and geographies. What is required instead is a strong and granular understanding of each asset’s contribution to portfolio diversification. To help with this, we have developed a tool to quantitatively assess diversification across a broader range of factors, with the rationale for their inclusion set out below.
The main event: Time of lease break or expiry
One of the most important risks to income in real estate is letting risk; the risk it takes longer to let out space than expected or that the rents achieved are below the expected level. The success of letting a property depends heavily on the economic conditions when it becomes vacant. As such, portfolios with variation in the timing of lease breaks and expiries will have less exposure to the business cycle position in any given year. Conversely, when lease expiries are tightly grouped, it exposes portfolios to unrewarded risk; it also acts as a drain on asset management resource when the number of lease expiries spike, which will likely lead to worse letting outcomes.
Investor appetite for assets with longer or shorter lease lengths tends to ebb and flow
Investor appetite for assets with longer or shorter lease lengths tends to ebb and flow at different stages of the real estate cycle. This can drive differences in capital growth, as shown in Figure 3, enhancing the case for lease-length diversification.
Maturing defined-benefit pension schemes looking to hedge inflation-linked liabilities have driven the development of a specialist long-income market in the UK over the last decade. With an increasing number of investors focused solely on this part of the market, the potential for long-lease real estate to perform differently to properties with shorter lease lengths has increased. This provides diversification grounds for traditional real estate funds to allocate capital to long-income assets.
Figure 3: UK retail units rolling 12-month returns, segmented by lease term (per cent)
Quality Street: Differentiation through asset selection
It is well known the performance of prime and secondary buildings can vary based on divergent occupier demand. At times when occupiers are more cost conscious, secondary assets with cheaper rents may outperform.
Asset quality is less often used as a factor in portfolio construction decisions
However, asset quality is less often used as a factor in portfolio construction decisions, perhaps due to the difficulty of objectively categorising buildings in this way. To help overcome this, we have followed the guidance of the Investment Property Forum3 and use rental value, compared to other assets in the same market, as a quantifiable measure of asset quality. This better reflects occupiers’ perspectives on the quality of a building, as market rental value represents the amount they are willing to pay. Quantifying asset quality in this way allows us to better assess portfolio diversification.
Know your tenant
To state the obvious, having a greater diversity of tenants across a portfolio reduces risk. High tenant concentration can increase income risk through exposure to tenant insolvencies or tenants seeking to reduce their floorspace, through either a Company Voluntary Arrangement or triggering break options.
Tenant concentration is usually assessed through a simplistic measure of exposure to the largest tenants
While real estate investors consider tenant concentration, this is usually assessed through a simplistic measure of exposure to the largest five or ten tenants. Instead, we prefer to use a sum of squared allocations as a measure of concentration risk, as we do across all sources of diversification. This more accurately quantifies the concentration risk across all tenants in the portfolio, not just for an arbitrary cut-off point. An illustration of this score for three theoretical portfolios is demonstrated in Figure 4.
Figure 4: Illustration of tenant allocation and concentration risk score (per cent)
Tenant industry can also be a source of concentration risk as the fortunes of companies in the same sector tend to be correlated, as does their propensity to renew leases. The COVID-19 pandemic has vividly demonstrated this with certain sectors, such as travel and hospitality, hit badly while others, most obviously technology, have benefitted.
Numbers game: Quantifying concentration risk
By looking at a wide range of measures and quantifying these appropriately, investors can better manage and understand concentration risk within their portfolios. We have developed a tool to score the diversification of a portfolio, enabling us to quantify diversification for each factor and get a holistic view on the impact of a transaction on fund-level diversification.
Figure 5 shows the concentration risk score before and after a proposed acquisition. The transaction increases the allocation to the largest market, yet improves portfolio-level diversification, reducing concentration risk as a result of the diversification benefits across other factors.
Figure 5: Quantification of concentration risk across various risk factors and aggregate portfolio score (higher concentration risk implies less diversified)
Beyond geography and sectors: A new path to diversification
The real estate industry tends to have too narrow a focus on sector and geography, with similar categorisations used in portfolio management. However, these factors account for little of the difference in performance between properties, often leading to inefficient and ineffective portfolio construction.
Concentrating on the factors that truly drive real estate differentiation improves the potential for alpha generation
By looking through a simple geographical lens, investors may quickly find their resources are spread too thinly, inhibiting their ability to develop local market expertise and generate outperformance. Instead, concentrating on the factors that truly drive real estate differentiation – like lease length, asset quality and tenant industry – improves the potential for alpha generation while maintaining portfolio diversification.