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Understanding real estate as an investment class

By Samvit Kanoria and Hasan Muzaffar

When it comes to real estate, institutional investors are changing the terms of engagement.

The portfolios of pension and mutual funds often include real-estate assets. Target allocations ranged from 9 to 10 percent for institutional investors between 2011 and 2015. Over that period, actual allocations rose steadily, from 6.7 percent to 8.5 percent.

Real estate can yield high returns, and it’s useful for diversification and as a hedge against inflation, but many see it as a high-risk play, particularly in developing countries. Barriers to investing include a lack of transparency, low liquidity, and undeveloped capital markets. That’s in sharp contrast with the rationale behind investors’ equity-investment strategies. For pension investors, 83 percent of real-estate allocations are in domestic markets; the figure for equities is 43 percent (Exhibit 1).

Foreign and domestic exposure for pension investors differ in equities, bonds, and real estate.

In this article, we consider two risk-mitigated trends in real-estate investment: nontraditional real-estate asset classes and building a direct-investment capability.

Real estate: Happy returns?

The performance of the real-estate market can be hard to gauge in markets where information is scarce and many transactions are private. To get a better understanding, McKinsey looked at the returns from more than 10,000 real-estate investments across asset classes in 14 major cities over a 19-year period through 2012. The study found that real-estate returns tended to be inversely correlated with those of conventional assets and thereby serve as a good diversification play for the portfolios of most institutional investors (Exhibit 2).

Real-estate returns tended to be inversely correlated with those of conventional assets.

Emerging economies will account for a large proportion of the growth in the global real-estate market because of the scale of new building in rapidly urbanizing countries with high GDP growth. As the scale of real-estate development in emerging markets rises, so too does the proportion of it available for private investment. In the past two decades, in developed markets, the share of investable real estate as a percentage of GDP has been stable, at 40 to 50 percent. In emerging ones, however, the percentage is growing (Exhibit 3), so investors may need to invest in emerging economies just to retain current allocations.

The share of investable real estate as a percentage of GDP has been growing in emerging markets.

Emerging trends

Two interesting trends characterize institutional investment in real estate. First, there is momentum toward nontraditional asset classes, such as student housing, data centers, healthcare offices, medical facilities, and assisted-living communities. Many of these are reaching investment grade, both by the size of deals and the number of transactions.

Global investment in student housing has more than doubled, for example—from $3 billion in 2007 to about $7 billion in 2015. In the United Kingdom alone, investor spending on student accommodations increased from £460 million in 2014 to £1.92 billion in 2015. In the United States, Wayne State University (in Michigan) recently closed a 40-year deal valued at $1.4 billion. In 2014, the University System of Georgia completed a $520 million deal to develop and manage student accommodations on nine campuses for 65 years.

Data centers, aided by advances in cloud computing, are another asset class gaining interest from institutional investors. In 2015, for example, Equinix, which provides carrier-neutral data centers and Internet exchanges to enable interconnection with data centers, was converted into a real-estate investment trust (REIT). As the volume and size of such deals increase, they become more attractive to institutional investors looking for scale.

Second, some investors, citing high costs and a perceived lack of control, are beginning to develop a direct-investment capability by building small teams of specialized investment practitioners. In a 2016 McKinsey survey of global institutional investors, 74 percent indicated that they were “likely” or “very likely” to build direct-investing capabilities. Moreover, direct investing could expand the sources of value creation to include operational improvements of assets. In the same survey, 51 percent of investors indicated that they were “likely” or “very likely” to acquire an operating platform to source deals and operate assets for the whole portfolio.

The traditional approach to real-estate investment is still very much alive. But with growth shifting to emerging markets, and with new business models in a range of nontraditional real-estate asset classes beginning to prove themselves, investors are more willing to consider new ways to find the returns they need. As always, though, the buyer must beware.

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