Real estate serves several important functions in a multi-asset class portfolio, including income generation, inflation protection, portfolio diversification and the opportunity for alpha creation. Real estate investments generate income through rent, which provides a regular source of return and liquidity. Real estate has been shown to provide strong inflation protection over the long-term. “Replacement cost”, the cost to build that property today, is an important determinant of value, and typically increases during inflationary periods due to the rising costs of labour and building materials. Additionally, rents, another important determinant of value, are also typically tied to consumer prices.
We believe real estate is an attractive asset class for alpha generation for several reasons. Real estate markets have low levels of institutional ownership relative to other asset classes. This results in under-managed assets generating sub-optimal income. Additionally, it results in poorly marketed sale processes creating the opportunity to acquire assets below fair market value. Lastly, skilled managers have developed highly repeatable business plans to reposition assets and drive net income growth on a consistent basis.
Investors typically categorise real estate strategies into core (high-quality assets, usually fully leased with stable long-term income), value-add (assets where there is potential to enhance value by leasing up vacant space or modest repositioning), and opportunistic (strategies offering the highest returns such as development, change of use, or substantial redevelopment / repositioning). Our focus is on value-add and opportunistic strategies, where we believe the alpha opportunity is greatest. These strategies have the highest degree of business plan complexity, and thus skilled execution is most impactful. We aim to partner with managers that are vertically-integrated, i.e., those with operating capabilities in-house in addition to investment and capital markets expertise. We believe these capabilities improve investment decisions and enable better business plan execution.
Finally, it is worth noting that the inclusion of real assets in portfolios is especially compelling for US taxpayers who can benefit from meaningful tax advantages.
We co-invested with an opportunistic real estate partner in the acquisition of a portfolio of multifamily properties in the US. The properties were located in attractive sub-markets, but had been unrenovated for several years, and as a result, rents were meaningfully below market averages. Our partner executed a full renovation of common areas, and initiated a refurbishment program for individual apartments, driving rent growth. The portfolio was sold less than three years after acquisition, and generated above target returns.