The real estate approach
One goal may be diversification and higher risk-adjusted returns. This “real estate” approach focuses on income-producing, high-quality properties in mature markets and employs low leverage. It generally feels familiar to Canadian institutions that are already invested at home – a market that is very mature – and that tend to invest in income-producing, high-quality properties and employ low leverage. For well-funded plans with rising real estate allocations, such an approach may be most fitting. However, as prices rise and yields fall within the domestic real estate market, and as property ownership becomes dominated by a few major investors and a limited number of private managers, institutions are increasingly hard pressed to put capital to work in Canada.
The question is, does investing beyond one’s home border require investors to take on more risk in exchange for the extra yield that justifies the perceived risks of investing abroad? Not necessarily. A global, core portfolio – one that includes Canada – offers a potentially better risk-adjusted return to Canadian investors than a domestic-only core portfolio. By going abroad, a plan doesn’t necessarily have to incur risks they otherwise would avoid at home (e.g., higher levels of development, leverage, vacancies). This real estate approach can work both domestically and outside of Canada.
The private equity approach
In contrast, other investors may be seeking higher absolute returns from their non-domestic real estate portfolio. This may be due to a plan being underfunded, or perhaps due to an investment philosophy that demands a premium from non-domestic investments. In such a case, plan sponsors can opt for more of a “private equity” approach that involves investing in a value-added or opportunistic style. What is the source of the potential higher returns targeted in these styles? The risks that don’t have a place in the real estate approach – development, leverage, vacancies – may be central to the strategies. But there could be additional factors at work.
Which approach to choose?
Managing those risks is key. For example, one U.K. pension fund took the real estate approach upon deciding that the limited size of their domestic real estate market would leave them overexposed and under-diversified. Other investors have recently chosen the private equity approach to capture, for example, short-term displacement and mispricing in mature markets, or perhaps mega trends (such as urbanization, demographics, growing wealth) evident in the emerging markets. Both styles – private equity and real estate – are fully sound when applied appropriately based on an investor’s risk tolerance and investment objectives.
Katherine Giordano is head of Americas, property multi-manager, Aberdeen Asset Management