How Diversified Real Estate Can Provide Value and Income to Wealth Advisors

Opportunity in crisis in Real Estate

“Buying right is hugely important and cannot be stressed too much. It is hard enough to make a well-bought deal work, but when you overpay for a property, the conclusion is inevitable.” - Francis Greenburger, Time Equities CEO

Assumptions about how Americans will live in the future have been suddenly called into question by the Coronavirus pandemic. The crisis has interrupted long-standing demographic and business trends while altering projections about the future of urban development and travel. Some of these changes are completely new, while others represent an acceleration of long-term changes trends underway in response to factors like climate change or evolving technologies.

Investors seeking to achieve diversification and enhance portfolio income can find opportunities in Real Estate as an asset class. Long term market returns prove that opportunistic buying is a cornerstone for successful real estate investment strategies over long periods of time.

The pandemic has created the potential for allocating to real properties at attractive valuations due to market disruptions, but careful consideration of risk factors is crucial. For wealth managers, the challenge is not only determining whether this crisis represents a buying opportunity but also how best to navigate risk going forward in a potentially volatile market environment through an economic recovery cycle full of unknowns.

Thinking Beyond 60/40: Wealth Managers Access Real Estate

Historically, wealth managers often segregated directly held real estate from other, more liquid, assets. This was due in part to a lack of access to reliable deal flow which complicated allocation decisions as well as the concentration of assets. With increased access to diversified portfolios of properties over recent decades, however, multi-family offices and private banks have increasingly mirrored the approach taken by pensions and endowments and allocated to real estate actively based on volatility and return assumptions.

Based on long-term data analysis, direct real estate as an asset class appears attractive to investors with access. Prior to the pandemic, NEPC published 5 to 7-year returns expectations of 6% for core Real Estate holdings with anticipated volatility of 13%, roughly matching expectations for large-cap US equities with a substantially lower volatility profile. As of year-end-2019 NEPC identified core Real Estate as the among the top five asset classes on a Sharpe ratio basis, rated higher than any public US equity or debt segment, including public and private REITs.

Road to Recovery or Ruin?

The impact of the Covid-19 virus on the global economy has been profound. Real estate markets felt the impact directly as government-mandated lock-downs and social distancing left offices, retail stores, and hotels vacant. Market intervention by the Federal Reserve and other global central banks subsequently lowered borrowing costs dramatically while increasing liquidity in credit markets.

The RCA US All-Property Commercial Real Estate Index increased by 4.9% Y/Y in May, the lowest rate of growth since 2011, with significant weakness in office and retail properties offset by resilience in family and multifamily units. Transaction volumes -historically, viewed as a leading indicator for commercial valuations, contracted by 79% Y/Y for May while the aggregate cap rate spread to Treasuries expanded to 87 basis points, slightly above historical averages. Critically, as commercial properties languished residential real estate prices have begun to exhibit early signs of a strong rebound helped by historically low mortgage rates. The NAR index of pending home sales increased 44.3% on a monthly basis after falling to multi-decade lows in April. Economists have debated whether this spike in home buying is sustainable or only represents a rebound driven by pent up demand that will falter without further stimulus.

Forecasts have become more clouded by recent events as increasing infection rates in states including Florida, Texas and California have led officials there to slow or reverse course on reopening.

As elected officials and corporate leaders consider the arguments for a “V”, “U” or “L” shaped recovery path for the US economy, the ongoing turmoil may present outsized opportunities and risks for real estate investors. It is important to consider that the shape of recovery from the pandemic may be different in nature from prior rebounds.

A Unique Inflection Point

During the credit crisis of 2007 and 2008 a sudden contraction of credit combined with a global recession depressed property values, creating buying opportunities for investors who were richly rewarded when central bank liquidity measures reflated prices. The market set-up facing real estate investors today sees similarly accommodative rate and liquidity policies that are augmented by massive cash reserves held by both institutional and individual investors.

The nature of the COVID pandemic, however, suggests that this recovery will be quite different from the last and that any economic rebound will be accompanied by lasting changes in consumer behavior and consumption patterns. As such, investors who buy assets at distressed prices without considering how these changes will impact future returns run the risk of falling into a value trap by confusing permanent changes in the way people live for cyclical trends.