Why is diversifying your portfolio with commercial real estate a smart move?

Source: Livemint

Diversifying one's investment portfolio is a key strategy to manage risk and optimise returns. While one can think that the universe of investable asset classes available today is vast and offers a variety of options to investors, in essence, there are only two things on any diligent investor’s mind while evaluating a potential investment opportunity:

i) Return of capital or capital protection (Safety FIRST)

ii) Return on capital (Risk-adjusted returns NEXT)

Most investment products can be placed on a continuum between the stability of fixed income (Government securities, bank FDs, bonds, debt mutual funds etc) and the volatility of equities (including direct stocks, equity mutual funds, ETFs etc).

An astute investor should look towards creating a diversified mix of fixed income, equity and hybrid security investments to optimise returns on his/her portfolio. Smart investors will try to find a balance between the high-risk & high-reward world of equities and the reliability of fixed-income (Debt) investments.

Needless to say, of paramount importance in the entire asset allocation process is liquidity (ability to quickly convert your investment to cash) and the ability to consistently generate REAL returns (investment returns measured against the yardstick of inflation).

CRE for portfolio diversification

While Indian investors have traditionally been heavy on real estate, a significant chunk of retail investor capital is historically allocated to residential real estate - which suffers from very low yields (sub 4% in most cities) and the returns don’t compensate for the inherent illiquidity of such investments.

It is at this juncture that I want to introduce commercial real estate. Commercial real estate provides 8-9% annual returns through rental yield and an opportunity to participate in the appreciation of the underlying property, giving it characteristics of both debt and equity. 

By virtue of being a real asset the principal amount is also considerably safer. The real icing on the cake is the annual inflation-linked rent escalations. Most commercial leases escalate by 5% every year or 15% every 3 years providing a strong cushion against inflation. The real rate of return is therefore always 8-9% with the capital appreciation providing the additional equity kicker.

CRE investments in the right institutional-grade properties with blue-chip tenants offer negligible credit risk of rents not being paid. A seasoned real estate investor will increase the stickiness of the tenant by requiring the tenant to do the fit-outs or TIs and by signing a “lock-in", a term used to bind tenants to a building for a longer term.

Also, the stability of returns (with monthly rental payouts to all investors) can be harnessed by using the monthly rental distributions to either reinvest in other assets through a  systematic investment plan or utilise them for recurring expenses. It also makes sense to build a large CRE investment corpus diversified across tenants, geographies and asset classes (offices, warehousing, retail etc).

In conclusion, while sophisticated and institutional investors have always been investing in commercial real estate, retail investors should consider adding high-quality commercial real estate as part of their portfolio. In order to effectively navigate your investments (managing tenants, finding the right investment and exit opportunities, rent collection, regulatory compliance etc). 

It is important to route CRE investments through a regulated and institutional investment platform, just like retail investors navigate equity markets through a trusted fund manager or a reputed fund house.