Investing in listed non-core real estate may offer investors a compelling opportunity for portfolio diversification while capturing growth within the evolving real estate market. We view listed non-core real estate as a building block for most institutional real estate portfolios. It can offer diversification by enhancing investors’ real estate portfolios with increased exposure to generally underrepresented, higher-growth property sectors, customized allocation to target investors’ specific needs and objectives, and the potential to increase total and risk-adjusted returns.
In this piece, we outline non-core and core real estate sectors, discuss the ongoing introduction, over time, of new property types into the publicly listed real estate market, and detail the potential benefits of completing real estate portfolios with publicly listed non-core investments. Potential benefits include:
- Diversification of investment allocation, while optimizing risk and return objectives and existing investment portfolios through bespoke customization.
- Immediate access to emerging and faster growing real estate sectors, which are often substantially underrepresented in private portfolios due to liquidity, access, or specification issues.
- Demand-driven non-core sector returns that outpace broader real estate and equities market growth.
What Is Non-Core Real Estate?
The landscape of publicly listed real estate has undergone significant changes over the years. Traditionally dominated by core sectors such as retail, office, apartments, and industrial, the market has witnessed a transformation with the emergence of non-core sectors. These non-core sectors have diversified the real estate investment landscape and encompass a variety of property types like data centers, healthcare facilities, life science, self storage, student housing, single-family home rentals, manufactured home communities, cell towers, gaming REITs, and alternative real estate assets. Such diversification is driven by the recognition of emerging trends and growing demands in the commercial real estate landscape. For instance, increasing reliance on technology, specifically artificial intelligence, has elevated the importance of data centers, while an aging population has amplified the need for senior healthcare facilities.
Growth of Non-Core Real Estate
Non-core real estate property types have demonstrated a continuing trajectory of demand-driven growth. While inflation appears to be moderating, we expect it to remain above the last 15-year average in the near- to mid-term. In such an environment, real estate should be poised to produce better real returns than the broader market, with non-core sector topline growth expected to outpace inflation and increases in expenses. For example, the healthcare sector’s senior housing component demonstrated the ability to grow topline revenue in the high single digits, while keeping expenses growing in the low single digits in 2023, and REITs with senior housing exposure expect robust fundamentals to persist in 2024. Non-core segments not only offer investors exposure to high-growth industries, but may provide a hedge against economic downturns, as they are often less sensitive to economic cycles compared to traditional sectors. For example, data center demand significantly outweighs supply, leading to higher rent growth potential and low occupancy. In 2023, data centers’ market rents rose over 20% and are expected to grow 10-15% in 2024.
As we look into the future, secular trends are expected to continue to drive higher earnings growth. Non-core property sectors are forecasted to post materially higher earnings in 2024 than core sectors, further evidencing ongoing secular shifts across real estate. The following chart shows the expected growth in funds from operations (FFO) over 2024, including greater expected growth for non-core sectors.
Non-core property sectors have shown excess performance compared to core property sectors, as seen in the following chart. The pursuit of niche markets and innovative property types has paved the way for these sectors to outperform, providing investors with the potential for enhanced returns. This excess performance can be attributed to the unique characteristics and dynamics of non-core assets, which include scarcity, technological advancements, highly specified organizational know-how, and changing consumer preferences. Self storage and single-family rentals are examples of non-core sectors that have produced outsized earnings growth. Self storage returns’ growth has been driven in part by the secular trends of baby boomers downsizing their homes and millennials residing in small urban apartments without ample storage space, and also by the ability of REIT managers to extract value at scale to maximize revenue potential. High single-family rental returns growth can be attributed in part to high mortgage rates and inflation, and lack of supply, which have led to a higher value proposition for renting as an alternative to ownership.
Public Non-Core Versus Private Real Estate
Despite the demonstrated growth and excess performance of non-core property types, private market real estate investing has been largely underweight non-core sectors. Private real estate allocations have traditionally favored core sectors, potentially giving an advantage to public REITs markets in providing investors with opportunities in the non-core real estate universe. By redirecting a portion of their private real estate allocations toward publicly listed non-core REITs, investors can strategically position themselves to benefit from the growth potential inherent in non-core sectors.
Non-core real estate is gaining a major and rapidly growing share of the REIT universe. From 2000 to 2023, non-traditional REITs’ share of the U.S. REIT market rose from 26% to more than 50%. As the real estate market has evolved, so too have investment guidelines, with emphasis on allocation target ranges for non-core sectors, which in many cases materially exceed typical private real estate allocations. Furthermore, core property sectors like the office sector may face strong headwinds. With the work-from-home trend persisting in the U.S., private sector allocations to the office sector remain significant, while the public real estate universe is made up of only 3-7% office. Clearly, the trend of non-core representing an increasing share of the public universe has attracted increased attention from private investors. In many cases, private investors have bought public companies at a premium. A recent deal announced the acquisition of a single-family rental REIT by a private investor at a 30% premium to the REIT’s trading share price. Also, REITs’ access to capital through the public equity and corporate bond markets may lead to increased opportunistic buys in constrained or dislocated markets. Public real estate focus and management expertise has been critical to maximizing the value of acquisitions and new builds. For example, a healthcare REIT recently projected high-single-digit to mid-teen unlevered IRRs on acquisitions. We believe, the breadth and depth of property-specific REITs, liquidity, and expertise of management are clear advantages for public real estate vis-à-vis private real estate.
Implementing a Non-Core Strategy
Investment in non-core real estate can be made in two simple ways: as a growth-seeking standalone investment or as a completion portfolio with bespoke customized allocations to optimize a client’s risk and return objectives. To implement a completion non-core strategy effectively, an investor should consider a broad mix of non-core sectors to complement their core private portfolio. Diversification across different property types, such as healthcare, data centers, and self storage, can mitigate risks and provide well-rounded exposure to non-core real estate. This approach allows investors to capture growth in sectors with unique drivers and dynamics, thus enhancing overall resilience and performance of their real estate portfolios.
Customization, via the inclusion of handpicked non-core sectors, is vital to implementing a non-core strategy that successfully meets an investor’s real estate needs and objectives as they evolve over time. Sector exposures in a listed non-core completion portfolio can be changed over time to mirror or complement an investor’s private real estate portfolio. An effective non-core completion strategy enhances a real estate portfolio with increased exposure to generally underrepresented high-growth non-core sectors, and is positioned to increase an investor’s total returns, diversification, and overall Sharpe ratio. As shown in the following chart, adding publicly listed non-core real estate investments to existing private allocations can increase return potential with a reduction in potential risk, which leads to improved Sharpe ratios. Our analysis concluded that a mix of 80% private blended with 20% public non-core leads to the highest Sharpe ratio, followed by a mix of 60% private blended with 40% public non-core.
In 2023, the average range between the top- and bottom-performing companies across each of 16 REITs sectors was 46%. With such a wide dispersion between best- and worst-performing companies across property sectors, active management becomes crucial. In this volatile landscape, the ability to carefully select individual names across sectors can increase performance potential and improves risk management. Applying careful bottom-up analysis, one can aim to navigate market fluctuations, focus on balance sheet health, and target companies with better growth prospects, instead of simply tracking an index.
Conclusion
Non-core publicly listed real estate presents a opportunity for investors looking to diversify their portfolios and capitalize on growth potential in real estate. By strategically incorporating a mix of listed non-core holdings in their real estate portfolios, investors can position themselves to potentially capture excess performance, complement their core private real estate allocations, or both, depending on their objectives. Non-core real estate holdings are a key to achieving complete and more resilient growth-oriented real estate investment strategies.
This material is for informational purposes only and not intended as investment advice or a recommendation to buy or sell any security. Information and opinions expressed are those of the authors and may not reflect the opinions of other investment teams within Duff & Phelps Investment Management Co. Information has been taken from sources we believe to be reliable, but its accuracy, completeness or interpretation cannot be guaranteed. Information is current as of the date appearing in this material only and subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. This material may include estimates, outlooks, projections, and other forward-looking statements. Due to a variety of factors, actual events may differ significantly from those presented. Investing involves risks, including the possible loss of principal. Duff & Phelps Investment Management Co. services are not available in all jurisdictions and this material does not constitute a solicitation or offer to any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation.