Filling the Basket: From Sector-Specific to Diversified Strategies, Investors Have a Variety of Options for Approaching Real Estate Investment

The wise soul who once said, “Don’t put all your eggs in one basket,” was probably unfamiliar with the complexities of the real estate investment market. Although that age-old proverb may resonate more with institutional investors pursuing a diversified investment strategy, those following a sector-specific strategy reject that sentiment — in a manner of speaking. Or perhaps it might be better to say they want to choose which baskets to fill, rather than leaving diversification up to their investment managers.

Experts say investors’ decision to follow a diversified strategy versus sector-specific strategy depends on many differentiators, such as the size of the investor organization, risk/return appetite and desired portfolio weightings, to name a few. Amid the many nuances of the real estate market, one thing is clear: Different things work for different investors, and one size does not fit all. Better questions might be, what works well for which investors, and why?

Why pursue a diversified strategy

Diversified strategies consider investments across all property types, strategies, geographies and throughout the capital stack, unlocking a range of opportunities that are carefully selected for the best risk-adjusted returns. This can be especially beneficial in the event of an economic downturn, to prevent market shocks from impacting the investment portfolio as a whole and reduce the volatility and risk of loss. Diversification can also be a powerful tool to maximize the long-term growth of a portfolio and achieve higher risk-adjusted returns.

“The most important factor in generating attractive net investment returns is through risk-adjusted gross investment returns at the deal level,” says David Butler, managing partner of Argosy Real Estate Partners. “Many believe that the best way to consistently generate above-average gross returns is to have access to a large, varied opportunity set that allows an experienced diversified fund manager to be flexible and opportunistic as market trends change.”

It’s this search for diversified opportunities that’s driving investors to funds such as the open-end TA Realty Core Property Fund, which recently received a $100 million allocation from the Public Employees’ Retirement System of Mississippi and a $50 million commitment from the Indiana Public Retirement System. TA Realty’s core strategy aims to construct and operate a diversified portfolio of institutional-quality, core real estate holdings in major U.S. metropolitan areas, with an emphasis on steady income generation.

Carly Tripp, global CIO and head of investments for diversified global investment manager Nuveen Real Estate, says one reason an investor may choose a diversified strategy is to put the impetus on the portfolio manager to make sector-level allocation decisions. In addition, some investors may be looking for real estate “beta” through a core strategy and aim to reduce tracking error.

One challenge with building a strong diversified strategy is having the resources to build a network capable of sourcing and executing transactions at the right scale. Managers of diversified funds are able to adjust to shifts in the market because of their wide exposure to different asset classes and geographical markets. The size of the portfolio and resources available are some key elements that must be in place, however, for this strategy to be successful.

“To achieve market-level returns within a diversified strategy, the underlying portfolio must be large enough to be considered truly diversified,” says Tripp. “However, the scale that is necessary also becomes a challenge of diversified strategies, in that many become so large that it hinders repositioning the portfolio allocations in a timely manner.”

Jeff Kanne, president and CEO of National Real Estate Advisors, says an investor’s size, both in terms of assets and investment team members, is typically the most important factor in determining allocation decisions. National, a build-to-core investment manager with a geographic and property diversification strategy, has found the smaller the investor in terms of assets and team size, the larger percentage of the organization’s allocation goes to a single diversified strategy. Larger investors will also allocate to diversified strategies, but typically these investors’ exposure to a single diversified fund is smaller, as they have the resources to invest in both diversified and sector-specific strategies.

Butler believes diversified strategies can be useful for investors of various sizes. “Both larger and smaller AUM fund investors should consider diversified funds to fill in the cracks in their investment portfolios to achieve more diversification … especially in the harder-to-access lower-middle market that is not covered by many larger diversified allocator funds,” says Butler. Argosy creates diversified opportunistic, value-added and core-plus real estate investment portfolios through joint ventures with local operating partners.

Why pursue a sector-specific strategy

A sector-specific strategy, although potentially riskier than a diversified one, can help an investor gain appropriate exposure to a thematic or growth opportunity, drive alpha within its real estate allocations, and take advantage of the expertise of a dedicated team. Furthermore, a sector-specific strategy gives investors more flexibility, allowing them to easily pivot their portfolio composition based on where outperformance is expected.

“Investing in sector specialists typically allows larger investors to configure and weight their portfolios in a more efficient format than through a series of diversified programs, and will enable them to control their exposures and weightings,” says Mit Shah, founder and CEO of Noble Investment Group. “Investing through a sector-specific strategy allows an investor to make tactical investment decisions efficiently.”

An investor might pursue a sector-specific strategy if its diversified funds do not provide enough exposure to a particular sector or subsector. The market has been flooded with these types of tactical sector-specific investments as of late. The $258.1 billion New York State Common Retirement Fund recently committed up to $30 million to Diversified Real Estate Niche Strategies (DRENS) Fund I, a real estate equity joint venture with The Macritchie Group. DRENS Fund I pursues a diversified storage strategy, focusing on developing and acquiring oversized-vehicle storage facilities, RV communities and industrial outdoor storage yards throughout the United States. Property types such as these seem to be moving up the “popularity” scale, and this suits a sector-specific strategy well.

Although “beds and sheds” — i.e., multifamily and industrial assets — are seeing much of the capital inflow these days, investors are increasingly looking at niche property sectors, such as life sciences, medical office, single-family rental, data centers, cold storage and student housing.

Recently, Pretium Single-Family Rental Fund III, a core-plus strategy managed by Pretium Partners, secured a $50 million commitment from the School Employees Retirement System of Ohio. The fund focuses on single-family homes in major U.S. markets that are experiencing above-average employment and population growth, and had raised more than $1.5 billion against an undisclosed fundraising target as of September 2021.

Heather Border, co-founder and managing partner at Alliance Global Advisors, attests to the trend of investors leaning away from the traditional property sectors in favor of investments in niche property types. She attributes this shift to emerging demographic trends and the uncertainty that came with the COVID-19 pandemic. This is, in turn, driving interest in sector-specific because, in the words of Kanne, “Capital flows to where it is most wanted.”

Property types with promise

As the market fluctuates, it is no secret that some property types are faring better than others. That has driven some investors to prefer a more sector-specific approach, to more closely target property types based on their overall risk/return appetite.

Shah explains while investing in “out-of-favor” sectors can be risky, it can also be a tactical way to navigate an oversaturated market. Take firms like Noble, a vertically integrated real estate investment manager focused on select-service hospitality. While Shah says a strong generational buying opportunity now exists for select-service and extended-stay hotels, the outlook for hotels was less than rosy in recent years. As the health crisis continues to subside, hotel operating metrics across the United States have improved meaningfully, and Noble has pinpointed substantial opportunities to acquire distressed hotels at significant discounts, add significant value and deliver outsized performance.

“It may not always be a good time in the market to invest in a specific sector, and a particular sector may be too crowded with investors, leading to higher prices and depressed investment returns,” says Shah. “If the sector is hot or overheated, an investor may be buying into it at the wrong time.”

Take multifamily and industrial, sectors that are stealing the limelight due to their reputation to perform well in an inflationary environment. Shah says these favored asset classes may actually be getting too much attention, resulting in high pricing and high entry points. He says it might be time to start thinking of other, less-favored asset classes to make tactical investments as part of investors’ real estate investment allocations.

Butler says diversified fund managers should also be positioned to shift their portfolio construction and apply greater concentration on niche strategies.

“As an example, while multifamily has had strong tailwinds — and strong price appreciation — over the last several years, we have tried to maintain exposure to the asset class through distinct niche strategies such as single-family build-for-rent, hotel-to-apartment conversions and condo de-conversions. On the other hand, as other asset classes confront headwinds, diversified managers should also be in a position to scale back exposure to these sectors with declining fundamentals,” says Butler. “There tends to be a herd mentality with asset classes that are in or out of favor, so the best diversified managers need to stay on the front end of the herd and know when to shift in and out of sectors as demand softens, or asset valuations stretch outside of what is justified by underlying fundamentals.”

Experts say, at the end of the day, staying ahead of upcoming trends and finding a partner with a strong track record of investing is crucial to success in both diversified and sector-specific strategies. Some specialty sectors require a level of experience that may not exist with a diversified manager, so in that case, working with a dedicated sector specialist could be a better bet. On the other side of the coin, Border says it can be more complicated to commit to a sector-specific manager if the investor is challenged by limited staffing or smaller allocations due to overall plan size. In some cases, an investor may have additional risk measures in place that would make sector-specific investments unattractive. It’s all about finding what fits best for the individual organization.

“It is important to partner with an exceptional operating partner, especially when it comes to some of the more [operationally] heavy strategies, such as data centers or cold storage,” says Border. “Often, these partners have a shorter track record than the larger diversified investment partners. In addition, some investors do not have enough resources to underwrite the operator and operational expertise and, therefore, will need to heavily rely on the consultant community to choose the best partner for each sector-specific strategy.”

How much does investor size matter?

Some experts argue the financial size of the investor doesn’t matter when choosing between a diversified versus sector-specific investment strategy. According to Tripp, Nuveen has seen both small and large investors prefer one strategy or the other. She says this is not dependent on how much the investor has available to invest, but rather if the investor has the staff to make the allocation decisions in-house.

“Oftentimes, this is dependent on internal expertise, but more so dependent on how real estate is used within their broader investment portfolio,” explains Tripp. “Do they want income, or is it used to top off a fixed-income portfolio? Or, are they looking at it as an extension of their private equity portfolio and, therefore, looking for alpha and equity-like returns?”

Butler believes sector-specific funds may be better suited for larger investors that have the resources and expertise to self-diversify their real estate investments. An investor must also be large enough to have the necessary resources to conduct detailed due diligence on the large number of sector-specific fund managers it must invest with to achieve sufficient diversification.

Shah says sector-specific funds offer attractive ways for mid-size and larger plans to balance and weight their portfolios tactically to generate alpha. Diversified funds, on the other hand, may be more appropriate for smaller investors, as these groups may not always have the capacity to analyze sector-specific or geography-specific funds that target alpha.

Clearly, there’s much for investors to consider when weighing their approach to real estate investment. To revisit our cautionary proverb, it’s important to carefully choose which baskets to fill, as you don’t want to be faced with broken eggs.

Kali Persall is a reporter with Institutional Real Estate, Inc., and editor of iREOC Connect.