Beyond bricks and mortar: The role of real estate investment in diversified portfolios

How did you come to be a specialist in this asset class?

When I joined Arbuthnot Latham, the team encouraged everyone to get involved in debates and discussions around economic topics. I quickly realised the research part of the job was absolutely something I wanted to be involved with, and the area that resonated with me most in the early days was real estate. For me, being new to the job, I found it easier to relate to the content and visualise the buildings across different sectors. This helped me better understand the context and consider the various factors impacting each sector.

How does real estate interact with and compare to other assets?

You can invest in property either directly or indirectly. Direct property investment involves buying the property itself or, more commonly, through a collective structure. When people think of property investing, this is more likely what they imagine, owning a share of a property or set of properties that aim to return capital growth and income.

However, this may not be desirable for some clients, especially those who need speedy access to their capital. Indirect property investments may be more desirable for such clients. This involves buying the shares of real estate companies which is typically through an investment vehicle called a Real Estate Investment Trust (REIT). These shares can be traded more frequently with greater price transparency relative to direct property. However, you are exposed to more volatility compared with directly owning a set of properties that may only change hands every few years.

This is important as it links to how real estate interacts with other asset classes. Indirect investment is like buying an equity and so its correlation to the equity market is high. Direct property investment returns are less correlated to equities because they tend to have infrequent valuations and transactions.

Real estate is considered a more defensive asset class because rentals tend to be fixed and indexed to inflation. This also means that property income is less sensitive to the economic cycle than other types of business. In recessions, both direct and indirect property tend to outperform global equities, providing diversification in a multi-asset portfolio.

How do we use this asset class in our investment services and portfolios?

We view property as an alternative asset class to complement other assets. Sitting alongside equity and fixed income, we invest in property to provide defence during volatile environments, while also providing positive returns during the good times.

In portfolios, our exposure has included both direct and indirect property. Irrespective of the vehicle we choose to invest, rigorous bottom-up research is required to ensure we identify the right opportunities.

Our own allocation has varied over time, though it has always been a part of our strategic asset allocation. We increased exposure in the aftermath of the pandemic as interest rates bottomed. This put us in a good position for 2022, when both stocks and bonds were hit by the rate hiking cycle and alternative assets were resilient.

We began reducing our position at the end of 2022, rotating back into fixed income and equities. Since then, we have remained tactically underweight to real estate, though we have been slowly adding to the position when we see attractive entry points.

What types of clients or investment goals is this asset class well-suited for?

What really drives the way an individual or company would invest in real estate, other than their objectives, is access and liquidity. For instance, a direct industrial property fund that has a lock-up period of five years and a large minimum investment may be suitable for larger institutions but may not be for retail investors who need easier access. They may prefer to invest in REITs for the transparency and the liquidity.

What are the big recent news events in your asset class?

The big focus has been on data centres. Long-term growth in demand for underlying infrastructure has led to enormous amounts of spending from the major artificial intelligence (AI) players.

McKinsey highlights that global critical IT data centre demand is projected to more than triple to 220 gigawatts by 2030 from 60 gigawatts currently. This means that we should expect to see a huge build of data centre capacity in the coming years.

What is your current outlook for this asset class over the next six to twelve months? 

Quite a few data points have been pointing to a higher-for-longer interest rate environment amid sticky inflation and a weakening but resilient labour market. Some of these factors may contribute to central banks in the UK and US keeping interest rates higher, which will be a headwind for real estate. If inflation was to moderate leading to central banks cutting interest rates more aggressively, this could be a positive catalyst for property.

Despite the challenging macro backdrop, there are still many reasons to remain constructive. Different structural and cyclical forces continue to benefit distinct areas of the market. Sectors such as industrials, data centres, and healthcare have outperformed in recent years, while offices and retail have lagged. This divergence highlights the importance of active management and the idiosyncratic opportunities that exist within the asset class — even during one of the most difficult periods for real estate in recent memory.

What is the most surprising thing you have learned while working in this asset class?

The sheer number and value of transactions is what surprises me. Even during the difficult times in 2022, many large value transactions were happening daily. The majority, unsurprisingly, comes from the US, and I read daily updates on deals being agreed with $100m values and above.

Find out more about our wealth management services. And if you want to find out more about how real estate fits into our investment management services, get in touch.