Learning the ropes

Real estate offers investors four key benefits. First, it brings diversification benefits to multi-asset portfolios. Real estate has low and sometimes even negative correlations of returns with other asset classes such as bonds and equities. Hence adding real estate to an equity and bond portfolio can improve the risk-return trade-off and mean that investors can achieve a desired level of return for a lower level of risk, giving them an enhanced opportunity set.

The second benefit is income from rents paid by occupiers of buildings through contractual lease agreements. Real estate owners also have the opportunity to grow and increase rental income by actively managing and improving properties. In doing so, they must balance the cost of any capital expenditure involved against the long-term benefits of an uplift in rental income. They could also look to reduce vacancy if part of a property is unlet.

The third benefit that real estate offers investors is the opportunity for capital value growth. This is partly linked to rental income, since managing a property to provide a higher rental income or a higher expected growth in rental income will boost capital values. Also, steps to make rental income more secure and less risky, such as long leases linked to inflation, can reduce the discount rates used for cash flow analysis and lead to an uplift in capital values.

Finally, real estate offers inflation protection. Property is a real asset and rental income typically grows in line with inflation. Short leases allow rents to be reset to capture inflation, while within-lease rents linked to inflation are another form of protection. Ultimately, though, what matters to investors is how the income protection feeds through to total returns. Looking at property returns across 26 markets globally dating back to 1980, we find that real estate provided inflation protection of 90% and that for a one percentage point increase in inflation property returns increased, on average, by 0.9 percentage points.