There is no question that 2022 was a tough year for commercial real estate and 2023 may not be much kinder to the asset class. Commercial real estate is typically purchased with leverage (i.e., loans) making property values quite sensitive to fluctuations in the cost of capital. As such, the sharp rise in global interest rates over the last 18 months is driving what industry pundits are calling the “great reset” in real estate values. Compounding the problem are some more specific issues in certain segments of commercial real estate, namely in office real estate due to the rise of remote work and in retail real estate, due to the ever-increasing online marketplace. Should long-term investors (most of us) stay away from this brewing mess?
A good place to start is to ask why investment advisors like investing in commercial real estate in the first place. The answer is simple: commercial real estate exposure has been quite beneficial to portfolios over the last few decades in terms of returns, diversification benefits and income generation. In the U.S., for example, public REITS (real estate investment trusts) have delivered an annual return of +8.2% over the last 25 years and this includes the -25% return the asset class delivered in 2022 and the -38% return the asset class sported in 2008. Public REITs have also outperformed the S&P 500 in 15 of those 25 years. In addition, REITs offer a good diversification opportunity, due to their low correlation with U.S. and global equity indexes (see figure 1 below) and their general lack of correlation with residential real estate. Finally, REITs have provided a higher dividend yield averaging 4.0% (roughly double what the S&P 500 has offered) over the same time period. Honestly, there are not many alternative asset classes that offer as much.
Figure 1. Correlation of U.S. Commercial Real Estate (REITS) with Equity Asset Classes
I think the above attributes are sufficient to argue that commercial real estate deserves a spot in most investors’ portfolios. But how much? Highly tactical investors might have concluded last year that it was time to sell out of the asset class entirely due to the rapid rise in interest rates (assuming they could correctly foresee how much the Fed was going to increase rates). Those same investors might have also concluded that it was time to sell out of growth stocks which were likewise affected by the rise in global interest rates. Indeed, the Nasdaq (a good growth stock proxy) declined by -32% in 2022, whereas US REITs fell by ‘only’ -25%.
But good luck timing the re-entry. I don’t know of anyone who correctly predicted that ChatGPT would take the world by storm giving a +39% return to the NASDAQ in 2023 through the end of June. It’s the old adage that it takes two good decisions to be successful at market timing, which almost no one can do on a consistent basis. That’s not how we invest at Artemis.
So how much real estate should you have in your portfolio today? Pure strategic investors (i.e., those who rarely adjust portfolio weights in light of market conditions), often point to multiple studies that have found that the optimal REIT allocation is between 5-15%, and surveys report that advisors typically recommend an allocation to REITS in the range of 4-12%.
At Artemis, we are neither market timers nor pure strategic portfolio allocators. We will dynamically alter our portfolio weights in light of market conditions. Last year, we did lighten up our allocation to REITs and most of our portfolios only have a 2-4% direct allocation currently (and office exposure is only 8% of the global fund we utilize). The near-term trajectory of the asset class at this point is largely a function of whether we are heading for a recession and whether interest rates will remain high challenging upcoming loan refinancing. If a recession looms, returns will suffer further (but so too will equity returns). Conversely, if inflation keeps coming down as it has in the last 10 months, leading the Fed to pause and then start reducing interest rates, 2024 could be an excellent year for commercial real estate. (Of note is that the asset class far outperformed the S&P 500 in the first few years following the end of the 2008 financial crisis.) It’s a tough call so we are staying put with our 2-4% allocation for now.
 The FTSE Nareit All Equity REIT Index