Thread by @manoj033

The beauty about real estate as an asset class is in it’s idiosyncrasies.

The key is "Portfolio Construction" with optimum risk-return characteristics.

A thread 🧵 on portfolio allocation & sizing within an institutional real estate portfolio 👇 👇 👇

Different real estate sectors come with different risk-return tradeoffs.

So to begin with, we need a framework to evaluate the quality of each sector.

I use 4 variables:

1) Operating Margins
2) Average length of stay
3) GDP Correlation
4) Technology disruption

Let's dig in.

1) Operating Margins

One of the easiest way to assess operating risk within a property type is through the 'operating margin' metric.

The higher the operating margins, the lower the operating risk, which is sometimes reflected in a lower cap rate for that asset class.

Recurring capex requirement is another large factor that influences operating margins greatly.

Case in point, the office asset class is a capex heavy asset class (recurring TIs etc.) and as a result suffers from low operating margins - one of the worst among all sectors.

On the other hand, self storage and manufactured housing have the best operating margins in the industry given how capex-lite they are to operate.

This isn't to say that property types with a higher operating margins are better from an investment stand point.

It really boils down to the risk-return tradeoff within each opportunity.

But, skewing your portfolio’s exposure towards sectors with higher operating margin goes a long way in building a robust portfolio given their inherent resilience.

2) Average length of stay

A higher average length of stay reflects in the durability of the asset class's cash flows.

A healthy exposure to sectors with high tenant retention will ensure optimal portfolio dynamics.

3) GDP Correlation

The higher the correlation to the larger economy, the more dependent the asset class is to GDP growth.

Office, retail and hotel are GDP-driven and are highly susceptible to economic downturns.

Industrial is an exception given it is supported by e-commerce tailwinds

On the other hand, sectors that are demographics-driven are much more resilient:

Self Storage, SFR, Multifamily --> Millennials

Manufactured Housing, Self Storage, Senior Living --> Baby Boomers

4) Technology disruption

Some sectors are ripe for technology disruption more so than other sectors and this must be taken into account for the long term.

Office, hotel & retail are most susceptible to technology disruptions while the housing sectors are more resilient.

Putting it altogether, here's a scoring chart that evaluates different real sectors across the 4 variables we just discussed.

Disclaimer 🤚

The scoring chart above is subjective to a certain extent.

It also misses several nuances within each asset class.

Eg: Within Office, Life Science Office & Medical Office score quite differently

So do strip malls & grocery-anchored retail from generic retail

The point about this thread was not to favor or dunk on any particular real estate sector.

Each sector has a place & role in a well-diversified portfolio.

The key is sizing --> An optimal mix of high alpha sectors combined with sectors that can anchor your overall portfolio.

Like with most things, there is no one answer that fits all.

Portfolio construction is an art. Not a science.

Personally, I skew towards over-weighting (70-80%) Housing / Industrial / Self Storage --> sectors that are demographics-driven and have tremendous tail winds.

And under-weighting (20-30%), Office / Retail / Hotel --> high alpha sectors that are more GDP-driven.

At the end of the day, an institution's goal is to build an all-weather portfolio that can hold it's own at any given point in an economic cycle.