The real estate sector may contain good options for equity investors searching for insulation from heightened market volatility, supply-chain disruption and the unfolding inflationary environment. To start with, real estate can and has performed well in inflationary climates by retaining value and providing income. And while most publicly traded real estate options are relatively undifferentiated developers—which are cyclical and lack durable competitive advantage—there are a select group of world-class real estate businesses that offer more. Finally, certain real estate businesses have been less impacted by the geopolitical factors and supply chain disruptions that have been a drag on some other sectors.
Types of real estate-equity investing
Investors have typically viewed real estate within a broader asset allocation alongside equities, cash, fixed income and alternative investments. And while most types of real estate are probably better held directly or in specialty vehicles, investors can get exposure to high-quality businesses in the public markets. From an equity investor’s perspective, the first thing to grasp is the breadth of the sector. It ranges from traditional development-oriented businesses often involved in local projects where future returns are determined by property sales, to specialized real estate asset managers with recurring cash flow.
The development business is most prevalent in emerging markets. It typically acquires land, entitles it, plans a project and then either sells or holds onto the completed project. The working capital cycle can often last years. Margins are often high for successful projects and disastrous for bad ones. On the face of it, the key to success for these types of business is having an advantage in either land acquisition, construction, marketing or cost of capital. However, it’s questionable as to how durable these advantages actually are. And many of them, like access to land, may be influenced by government. Companies whose advantage is proximity to government often see their advantages fade if they fall out of favor or the government changes.
Visibility and flexibility
A smaller subset of real-estate businesses are less about development and more about recurring income. These business models are quite diverse and may range from those that actually own lots of real estate to essentially third-party managers.
Businesses that own or operate real estate differ greatly in their operational intensity. Some are almost akin to fixed income with relatively predictable and long-term distributions of cash and others are operationally intense and have greater upside potential but also more volatility or risk.
Similar businesses are influenced by geography as well. For example, office buildings, warehouses and logistics facilities tend to have shorter lease terms in most parts of Asia when compared with the U.S. This can allow leases to be adjusted upward more frequently in periods of rising prices, which can potentially provide more upside in inflationary environments but less visibility and defensiveness in a down market.