Diversifying the portfolio with real estate investments

As an investment, the case for real estate remains iron clad. Not only has the sector outperformed the S&P 500 over the past 40 years (an average annual return of 9.3% for the NCREIF Property Index versus an 8.7% return for the S&P 500), it’s done so with dramatically less volatility (7.8% compared to 16.4%).

Yet many investors continue to sit on the sidelines, still spooked by the tumble in real estate values that accompanied the financial crisis and failing to realize that prices have not only fully recovered, but as of the end of 2015 real estate produced a 53% total return (including both asset value increases plus investment yield) since the NCREIF Index peak of 2008.

After a prolonged run-up, it’s only natural to question whether we’ve reached the peak of this current business cycle. But even if that is the case, it by no means necessarily translates into turbulent waters for real estate. Historically, real estate cycles and business cycles rarely coincide. In fact, as the chart below depicts, there’s an extraordinarily low correlation between the two. Since 1981, there have been a total of six years in which the S&P 500 posted negative returns. In all but one of those years, commercial real estate provided positive returns. The S&P delivered an average 14.6% loss during those years while commercial real estate delivered an average 6.4% gain.

Where are we in this real estate cycle?

First and foremost, steer clear of anyone who claims they can precisely time real estate cycles. What a thorough analysis of historical data can determine, however, is that over the last 200 years the average duration of a real estate cycle is 18 years. So if this market is consistent with historical averages, the next correction shouldn’t occur until sometime around 2026.

It is important to understand the four stages of real estate cycles (recovery, expansion, hyper-supply and recession) and aligning our investments along the risk spectrum to maximize returns throughout those stages.

The four risk buckets we focus on are:

– High Yield Core Properties — prime properties in highly desirable locations with strong rent rolls, low leverage and well-maintained PP&E.

– Light Value Add Properties — stabilized properties in core, core adjacent or gentrifying-to-core locations with strong leasing histories, but a higher return due to weak management and/or moderate deferred maintenance.

– Repositioning/Reconfiguring Properties — unstabilized assets with significant vacancies and below market rents that can be repurposed with capital improvements.

– Entitlement & Development Properties — unique opportunities that can be executed quickly using “by-right” entitlements to speed the development process.

At the beginning of a recovery, we invest primarily in the entitlement/ development end of the risk spectrum. As expansion accelerates, we then strive to invest evenly across all four property types. When structural vacancy reaches 5% nationally we cease all entitlement/development activities. And when vacancy rates hit 6% nationally, we invest exclusively in high yield core or core plus properties.

Given the current 4% vacancy rates, we believe we’re firmly ensconced in the middle of the real estate cycle (the expansion phase), which based on both vacancy and pricing data we expect to continue through at least 2018.

Even the most ideally timed real estate investment, however, won’t prove fruitful if a high degree of prudence and care aren’t employed in making the deal and hedging risk. With the exception of development properties, we only use fixed rate, long-term debt. And we refuse to over-leverage. If the only way we can make a deal work is with high leverage debt, then it’s time to step away from the table.

Even on development deals where short-term, floating rate debt is the only option, we negotiate hard for term extensions that will provide sufficient time to weather a cycle correction. And we diligently employ rate hedges to protect against rising rates.

It’s an immutable fact that real estate values can drop significantly during a market correction. But with a smart, structured and disciplined approach to investing, success can be achieved through all stages of the market cycle, with the added benefit of enhanced portfolio diversification using non-correlated assets.

The key is timing. When you’re not forced to sell, refinance or recapitalize, you’re afford the flexibility to ride out down cycles and therefore avoid taking losses.

Bob Champion is president of Champion Real Estate Company