Registered investment advisers (RIAs) have spent much of 2020 reallocating their clients’ portfolios as the recession gripped the equity and debt markets and the COVID-19 pandemic plunged the global economy into severe contraction. The extreme market dislocation caused by the pandemic has caused many RIAs to look for alternative investment opportunities that will sustain value and cash flow through a downturn and be well positioned when the recovery begins.

RIAs can take a page from family offices that have historically relied on real estate to provide downside protection, income and capital preservation in their portfolios. In uncertain economic environments, as we are experiencing today, stable assets bring outsized value to an investor’s portfolio. Real estate has proven itself to be exceptionally stable during historically volatile periods, and the COVID-19 recession has been no exception.

BEST PRACTICES IN REAL ESTATE

Funds are comfortable territory for many RIAs, but public real estate funds are often too correlated to the equity markets to offer the benefits that private real estate offers. RIAs are no longer restricted to REITs as their sole strategy. A strong case has emerged for RIAs to consider private direct investments in real estate — either through thoughtfully constructed portfolio vehicles or direct co-investments. Private funds offer RIAs a way to get comfortable with direct investments in real estate, while still providing the diversification benefits most clients require in their illiquid allocation.

The transparency in most types of direct investments in real estate has changed significantly over the past decade, providing more opportunities for RIAs to increase their clients’ allocations to investments in real estate. This is appealing as advisers seek to replace fixed-income sources in a near 0 percent interest rate environment.

Historically, if you wanted nonpublic real estate as an RIA, you only had two options: (1) nontraded REITs or (2) small club private placements. However, today’s investment landscape provides more diverse opportunities for RIAs to pursue direct investments in real estate — and in a more transparent and structured way.

VALUE STABILITY

Real estate investment can add increased stability to a portfolio in a highly volatile macro-environment. Real estate also outperforms the S&P 500 when it comes to risk-adjusted returns. In fact, on average during past recessions when real estate values fluctuate negatively, they decrease 43 percent less than the S&P 500. Additionally, the standard deviation of real estate values during past recessions, which measures volatility, was significantly smaller than that of the S&P 500.

Of all real estate types, multifamily apartments have proven to be the most stable as it benefits from several demographic and economic trends that have driven unprecedented renter demand, making multifamily especially defensive and worthy of consideration to further insulate portfolios against a broader market decline and inflation. This durable demand has helped bolster multifamily returns and valuation stability throughout previous recessions and has made it one of the strongest investments available when adjusted for risk.

The resiliency and durability of the multifamily sector is continuing during the current downturn, as exemplified by the sector’s stable rent collections during the COVID-19 recession, with only the industrial sector having consistently collected a larger share of its contracted rent payments during this period. This trend underscores multifamily tenants’ prioritization of rental payments as compared to the tenants of other property types.

Fixed-income instruments, such as bonds, have historically yielded low but stable returns, while equities have yielded nearly double those of fixed income, but with significantly more risk. Real estate offers the best of both worlds. Value-added real estate combines bond-like attributes of 4 percent to 8 percent current income, with the potential for capital appreciation, much like dividend-paying stocks and ETFs, but often with less volatility.

An additional benefit of multifamily real estate over other real estate sectors is its ability to hedge against inflation through periodic inflation-indexed rent adjustments. Multifamily leases are, on average, one-year long, whereas retail, office and industrial leases generally range anywhere from three to 10 years. The shorter lease duration allows for more frequent and deliberate rent adjustments that can account for and offset rising costs.

RISE OF THE RENTERSHIP SOCIETY

The United States is increasingly becoming a nation of renters-by-necessity as wage growth has remained stagnant, failing to keep pace with home prices, which have skyrocketed due to general undersupply, as average debt per household has increased. Rising student debt among the millennial and Gen X cohorts, coupled with lower household savings and discretionary funds, and reduced credit scores, have further impaired a household’s ability to afford the down payment required for a home purchase. Collectively, these factors have significantly reduced the potential for homeownership. This unaffordability issue is a main driver of the increased demand for multifamily housing in the United States, as those households that have been priced out of homeownership must rent.

Even before the pandemic, these shifting demographics and corresponding economic pressures have contributed to the rise of multifamily investment as the United States has generally shifted from a nation of owners to one of renters. The COVID-19 recession is likely to push even more people into the rental market and will create further benefits for multifamily real estate investment going forward.

The multifamily market’s inability to keep up with increasing demand has been especially impactful on the country’s population of workforce households — those earning between $35,000 and $75,000 per year. As of 2018, there were 1.8 million more workforce renting households than there were workforce apartments. This supply/demand imbalance has resulted in significantly lower workforce apartment vacancy rates in comparison to the luxury sector.

THE WIN-WIN IN WORKFORCE HOUSING

Private fund investments in the workforce housing sector sustain value and cash flow through an economic downturn and can be well-positioned when the recovery returns. Workforce housing in class B and C multifamily buildings offers a lesser-tapped market with good fundamentals for investors — steady demand, low vacancy rates, and the ability to incrementally raise rents with low capital expenditure on improvement.

In response to the increased volatility exhibited during the COVID-19 recession, and the sector’s historical financial outperformance through recessionary environments, RIAs should consider allocating additional portfolio weight to multifamily real estate. Investors who finance workforce housing can also feel good that they are helping to fulfill a desperately underserved social need, affordable housing, that will only increase during the COVID-19 recession.

Ken Munkacy is senior managing director of Kingbird Investment Management.