Life, Liberty and the Pursuit of Property

Real estate & active management

Life, Liberty and the Pursuit of Property

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


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IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.

Diversification does not guarantee a profit or protect against loss.

Yields and dividends represent past performance and there is no guarantee they will continue to be paid.

Active management does not ensure gains or protect against market declines.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.