Given its low correlation to other asset classes, an allocation to real estate can serve as a strong diversifier in a portfolio while also helping a scheme meet its income and return targets.
Indeed, rental yields and property values in most areas of the market - apart from the retail sector, which was already facing structural challenges before the Covid-19 pandemic struck - have remained resilient over the past 12 months.
As a result, there has been little incentive for schemes to diversify their real estate allocation and most have remained domestically focused despite global opportunities becoming more accessible in recent years.
However, the investment landscape has shifted since the coronavirus took hold, with rates cut even further from post-global financial crisis lows and the economic outlook linked to the Covid-19 recovery. This poses some challenges for core real estate allocations, where we expect lower returns than have been enjoyed in the past.
Rental income is expected to remain robust, but capital returns are expected to be lower in the coming years, according to our Long-Term Capital Market Assumptions report.
Faced with lower expected returns from the asset class, schemes that wish to make up the shortfall have typically been driven towards two options: to enhance returns through active management, or extend portfolios into value-added and opportunistic real estate. However, there are potential issues with these two approaches.
Firstly, a narrow dispersion of returns between top- and bottom-performing open-ended strategies suggests that performance is more beta-driven and that identifying consistent alpha-generating managers is difficult in the core real estate space. Secondly, adding non-core real estate assets may offset lower expected returns from core assets, but it can also increase the risk profile of a scheme's real estate allocation.
Other more risk-averse schemes that have been focused on de-risking before and through the pandemic are typically seeking out sources of stable cash flow in the long term. These schemes may have been "doubling down" on their real estate exposure with "super core" assets.
Although such lower risk "secure income" assets - such as long-lease property and ground rents - have held up well over the past year or so, higher demand has driven yields down, making high quality income streams more expensive and, for some, potentially out of reach.
So, maybe it's time for schemes to diversify and add some global exposure?
Our research shows that global diversification can help schemes achieve the stable income and attractive returns they have come to enjoy from core domestic real estate assets. It can also provide an effective hedge against domestic inflation.
