With the many economic forces at play, investors are thinking more deeply about reconfiguring their real estate portfolios in a more defensive posture. One of the proponents of such measures is Todd Henderson, head of real estate, Americas, DWS.

What is defensive investing?

Defensive investing is defined as making investments that provide stable cash flow, as cash flow has historically made up a significant portion of the return in core real estate. In addition, in an environment that may see downside volatility in demand for leasing and deteriorating credit quality, it means limiting the amount of capital spent per unit of income on a property. By owning a portfolio that has stable cash flow and limited capital expenditures, returns will be less volatile as we weather a low appreciation cycle over the next two years.

What does defensive investing defend against in the current environment?

The current market environment is replete with risk factors. There is geopolitical risk, interest rate risk, inflation risk, and the risk of a slowing economy with the prospect of recession in 2023. A defensive portfolio construction strategy attempts to defend against all of these factors.

Real estate, as an asset class, has proven to be a good inflation hedge, but there are certain sectors within real estate that are better inflation hedges than others. Those sectors with short-term lease duration (i.e., apartments, self-storage) allow for lease rates to be reset more quickly than those sectors characterized by longer-term leases.

Certain sectors are more correlated to the business cycle than others and therefore have high volatility in an uncertain economic cycle. For example, the office sector has a high correlation to the business cycle and the highest volatility in terms of return. This sector also typically has the highest capital expenditures per unit of income. Given the current environment, real estate portfolios should underweight the office sector.

Should defensive investing be a perennial strategy or employed only during specific economic situations?

Investors should always evaluate risk and decide how to tilt their portfolio construction — no differently from traditional asset classes “risk on” or “risk off” approach to their portfolio construction. Real estate has performed best in low interest rate and high GDP growth markets. A less defensive portfolio construction posture is warranted in this environment.  Alternatively, a more defensive posture is warranted in a higher interest rate and slower growth environment.

What defensive assets should be committed to at this stage?

Real estate is coming off one of the best years we have seen in terms of fundamentals and total return. However, the dispersion of returns across the different sectors within real estate has never been greater. In 2021, the difference between the best-performing sector (industrial) and the worst-performing sector (retail) was 39 percentage points. So, portfolio construction has never been at a higher premium.

The industrial sector benefits from strong ecommerce demand, inventory rebuilding, and regionalization of supply chains to create supply chain resilience. This demand has driven industrial vacancy levels to historic lows. These structural demand generators will continue to support rent growth that keeps pace with inflation and coupled with the low amounts of capital required for industrial buildings, the sector should continue its outperformance in this environment.

In addition, we like the residential sector in this environment — everything from traditional multifamily and single-family rentals to student housing. There is a housing shortage in this country that has driven unprecedented rent growth over the past year. At current development pacing, the gap in rental housing will not be closed in five years. Demographic trends are also supporting the residential sector as we are seeing strong household formation from both the millennial and Gen Z populations. Furthermore, we are seeing empty nesters from the baby boomer and Gen X populations sell homes and move into rental housing. As previously mentioned, we like the inflation hedge provided by the short-term leases in residential real estate.

What assets should be avoided or divested?

Generally, the office and the retail sectors should be avoided in this environment. Office is highly procyclical, and remote working may worsen its prospects in a downturn. Sluggish rents will fail to offset the effects of higher interest rates, dragging office values lower. However, it is important to note that state of the art “next generation” buildings, located in high population growth markets, have demonstrated stability.

Retail suffers from continued ecommerce pressure and the prospect of a recessionary impact on disposable incomes impacting discretionary retail spending. With that being said, the necessity-based retail centers should hold up well. A post-COVID recovery in this subsector of retail has led to a 17-year low in vacancy rates.