Active management can open the door to real estate opportunities that may enable investors to build more diversified portfolios.
Pension funds, university endowments and select private investors are among those who have long used real estate to enhance income and appreciation opportunities and to diversify risks in long-term portfolios.
But a broader group of investors today are able to access real estate opportunities through products that offer lower minimum investments and more suitable levels of liquidity than what's been available via traditional direct investment in the sector.
Yet real estate has unique complexities that make the sector particularly compatible with active management. Indeed, as market complexity increases, information about individual assets and market liquidity can be limited. And that can actually play into the strengths of active managers experienced in analyzing individual opportunities to construct diversified portfolios that may offer attractive risk-adjusted return potential.
Market complexity and active management: A conceptual relationship
An allocation to real estate can offer a lot to investors, including attractive income, appreciation potential, inflation protection, low volatility and diversification from the price movements of more traditional asset classes.
Yet the sector is not without risks. Every market and submarket behaves differently, because local economic conditions directly impact labor markets and population growth, which really drive supply/demand fundamentals. And while that adds to complexity, it may also create opportunities for those who understand the idiosyncrasies of real estate.
The best assets in the best markets
In any market, but especially one as large as the United States, it is important to identify and effectively value the best assets in the best markets—what active managers in this sector refer to as “core real estate”. Whether office buildings, retail centers, apartments or industrial buildings, the best properties tend to attract the highest quality tenants and the best markets may prove the most sustainable throughout a full business cycle.
In addition, selecting the best assets in the best markets involves acquiring effective professional property management as part of the overall investment. Landlords that effectively manage leasing agreements based on both the competitive landscape and the business cycle can help sustain and grow current income. In many cases, office and industrial leases are written to “step up” at the rate of inflation throughout the term of the contract.
Since every market behaves differently, pricing will fluctuate according to local fundamentals. That means some markets may be overvalued when others are undervalued, providing active managers with opportunities to choose investments under the most favorable conditions across different property types, regions and metro areas and industries. Investments in attractive, but more highly valued areas can be delayed until pricing becomes more favorable.
Taking it all into account
Clearly there are numerous factors in real estate—the asset itself, the local market, the management, contractual terms of leases, current pricing—that meld to determine the level and sustainability of cash flow and the diversifying benefits to a broader portfolio. And as with any investment, the price paid is a major determinant of total return potential.
A broad-based index approach to this asset class is unable to take into account many of the factors unique to core real estate investing. Indeed, passive strategies are grounded in the belief that markets are too efficient for active managers to reliably exploit over time. However, this disregards the obvious fact that markets vary considerably in terms of type, size, diversity and liquidity—key determinants of real estate markets' complexity and the potential for exploitable pricing inefficiencies—and therefore potentially greater return.
Through determining which issues to include—and exclude—from the portfolio and how to weight each of them; as well as by taking advantage of opportunities to buy and sell as market conditions fluctuate, active managers offer investors a different overall risk/return profile than they could achieve through an all-inclusive passive index-based approach.
Legg Mason affiliate Clarion Partners has over 30 years of experience developing real estate and identifying best-in-class asset solutions that offer investors opportunities in high quality properties in sectors including office, retail, industrial, multifamily residential and hotel), bringing the potential benefits of this remarkable diversifier within the reach of individual investors.
This is the second in a series of articles about specialized sectors where active managers could have a natural advantage over passive strategies. Look for upcoming articles on active management in direct lending and alternative strategies.
For insight on infrastructure and active management see “Build it and they will come”