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Cape Town - Recent global political, economic and market uncertainty raises the important question of how investors can increase the resilience of their real estate portfolio.
According to Sebastien Lieblich, head of equity solutions at research company MSCI, the answer to this question boils down to three simple portfolio construction strategies: asset selection; sector allocation; and global diversification.
In his view, asset selection tends to be particularly important for smaller portfolios since they may consist of only a few assets and are, therefore, dominated by asset-specific risk.
"Only the largest portfolios can hope to allocate in sufficient volume to provide diversified sector or market exposure," Lieblich explained in MSCI’s first Real Estate Research Snapshot 2017.
"Proper asset selection is crucial in private real estate. Every property is unique and hence no portfolio, whatever its size, can perfectly represent the market."
For this reason, 50% to 60% of the tracking error between a private real estate portfolio and its benchmark is generally attributable to asset selection. Smaller portfolios with proportionately larger exposures to individual assets are even more exposed to this phenomenon.
He goes on to explain that variations in portfolio returns are driven by the unique characteristics of each asset. That would be, for instance, its physical characteristics; location through to its lease structure; and the strength of its tenants.
"While it is impossible to perfectly diversify away asset specific risk, the resilience of portfolios can be enhanced by combining real estate assets with varying characteristics and by actively managing the physical and cash flow characteristics of the assets themselves," said Lieblich.
Sector allocation offers another opportunity to build portfolio resilience, in his view.
"By allocating capital to the right sectors, it is possible to strengthen the defensive nature of the portfolio," he said.
He added that global diversification has historically offered even more resilience benefits than sector allocation up front.
Internationally, there has been a wide range of performance, with over 13 percentage points of difference in the annualised total return of the best and worst performing markets in the eight-year period from 2007.
To him this large gulf in performance highlights both the potential of global diversification and the importance of managing it properly.
"Most private real estate portfolios are too small to take advantage of these global diversification benefits and thus exhibit a strong home bias," said Lieblich.
"Consequently, cross-border correlations remain low. Funds that are big enough to exploit these low correlations can produce greater portfolio resilience."
He said the basic strategies of asset selection, sector allocation and global diversification can be borrowed from publicly listed asset classes. However, they must be applied carefully, given the unique characteristics of the private real estate market, he cautioned.
"Private real estate market data built from the bottom up with detailed asset-level cash flows can help investors optimise the mix of these strategies in a way that is suitable for their portfolios," he said.
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