Overview
It turns out that location, location, and location aren’t the only considerations in real estate investment, after all. This week’s Chart Room compares the risk-return profiles of two models of real estate portfolios over the last 15 years: one that invests in different types of buildings including homes, hotels, offices, and retail units, among others (the blue ‘sector’ bar[1]), and one that invests in assets across different European markets (the orange ‘country’ bar[2]). In both scenarios the analysis found a direct correlation between investing in more countries and sectors and increasing returns. In other words, it really does pay to diversify.
Spreading investments across both different locations and categories tends to improve a property portfolio’s risk-reward profile, according to our research. But our model also suggests that over the last decade and a half, sector-based diversification has offered a better risk-return profile than geographical diversification.
Partly this is because the European market has become increasingly integrated – if a poor economy is damaging the office market in Germany, for instance, then a similar dynamic is likely to play out for offices in Italy, France, or Norway.
Significant too is the way in which different structural trends can affect the prospects of different types of buildings, meaning that a portfolio made up of a blend of these assets can have a stronger risk-return profile. For example, a Covid-induced slowdown in the offices and hotels sectors coincided with a surge in online shopping that increased the value of big box warehouses. Dynamics vary even within sectors themselves: although many high-street retailers struggled over Covid, large DIY stores selling goods that do not have a high online sales penetration rate were allowed to stay open, supporting rent collection rates and boosting turnover-linked income.
Our propriety models are based on the markets over the last 15 years, but much could change over the next cycle. Since the Global Financial Crisis, low interest rates have compressed yields globally, and so by comparing different types of European real estate model portfolios we’ve seen the benefit of diversifying by sector. But over the next cycle, performance across different economies could begin to diverge even more. Already, inflation is rising quicker in the UK than the rest of Europe for example, and so we have seen the commercial real estate market there repriced far quicker than in the rest of the continent.
As such, this chart could look very different in 10 years’ time and the risk-return profile of portfolios diversified by geography could be stronger. But for now, investing across different sectors remains the key diversification play.
[1] For this model we looked at investments across residential assets, hotels, offices, retail units, industrial buildings, and all property.
[2] For this model we looked at investments in the UK, Germany, France, the Nordics, Eastern Europe, and Southern Europe.
