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Why real estate makes a good bet for portfolio diversification in a crisis

Why real estate makes a good bet for portfolio diversification in a crisis

15 Aug 2021

For an investor, true portfolio diversification is achieved when the portfolio is invested across un-correlated assets. At the simplest level this is achieved by taking a risk appropriate exposure to shares and bonds. However, as surpluses increase, one can also look to add gold, commodities and real estate to your asset allocation. Research suggests that your asset allocation tends to influence almost 91.5% of your returns rather than your choice of stocks or timing the market. Hard assets like gold and real estate tend to do better in times of rising inflation expectation.

In fact real estate world over is seeing a flow of institutional money in recent times. One reason is that the rental yields were higher than the interest rates in most developed economies; However, the stability of cash flow, the resilience of certain segments even in wake of the pandemic, and low correlation with the equity markets have established Real Estate as an asset class to reckon.

Any asset class that attracts large money brings in innovation and the development of new segments. New instruments like REITs, tokenization are emerging along with the non-traditional sectors comprising of Data Centers, Senior Living, and Self-storage, that are witnessing above average growth as the sector adapts to the changing times.

Data is the backbone of the digital future. With the growing data needs, the requirements of data storage are also increasing. Instead of storing the apps and data on a server in the office premises businesses are migrating the data to the cloud or are using remote locations for data servers. This has propelled the demand for physical space for housing servers, routers, switches, etc for cloud service providers and businesses.

An aging population, nuclear families, preference for independence are shaping up Senior Living as a niche category in the US, UK, France, and Germany. Senior living apartments are specifically designed with the wants and needs of older adults in mind. Elements of a traditional home that are challenging at an old age such as stairs, high cabinets, etc. chores such as cleaning, laundry, and other household duties are taken care of in the Senior living communities through an echo system replete with hospital/medical centre, laundry and housekeeping services, much more. Many adults above 62 years of age are selling their houses and moving into such communities on rent, attracting capital to this space in parts of the developed world.

Self-storage businesses offer space-strapped customers a secure place in which to store things they don’t need right now but can’t bring themselves to throw away. People use self-storage for many different reasons, including household downsizes, renovations, relocations, military posts, and for holding business records. These facilities have become big business; nearly 1 in 10 American households uses one of about 50,000 self-storage facilities. The sector has generated more than $22 billion in annual U.S. revenues, and rentable space now totals more than three times the size of Manhattan Island. These are small but growing components of the sector.

The mainstay for real estate investors remains the traditional mix of commercial and residential properties. Areas like warehouses, cold storage, and urban space for the last mile retail delivery are on the investors’ radar due to the boom in online shopping. Rent is a small proportion of a logistics operator’s total operating costs and is also much lower than total transportation costs arising from deliveries. This leaves greater scope for landlords to command rental increases in well-located submarkets that enable a logistics operator or retailer to strike a balance between delivery speed, warehousing, and transportation costs In the era of asset light businesses, more and more businesses are leasing office space instead of buying. This has created a space for large institutions to buy offices and earn a rental income from quality tenants. Though the pandemic has seen an acceleration in the work from home concept, offices are here to stay.

Most good companies will look at smaller offices but will upgrade to what are typically termed as Grade A buildings. Multiple factors like mobility, low affordability, unwillingness to lock in large capital are driving more individuals to stay in rented apartments. Large institutions, investors are building urban apartments and renting them out for regular cashflows. Real estate is a very local play. What applies in Mumbai may not be relevant in Tokyo. Dynamics in New York for residential real estate are completely different from Paris or Berlin that have a cap on rentals. The supply of Grade A offices in the US is dwindling with 70% of office space was built before 1990 whereas Seoul, Shanghai, and Melbourne are seeing an increased supply.

I hope that this has helped give better perspective to an asset class that is a traditional favourite in India.

Happy investing.

(The author, Ajit Menon is CEO of PGIM India Mutual Fund. The views are his own)