Authors

Grant Alexander Wilson, Ph.D., Assistant Professor, Faculty of Business Administration, University of Regina

Jason Jogia, MBA, M.Fin., Chief Investment Officer, Avenue Living

Author Bios

Dr. Wilson is an Assistant Professor at the Hill and Levene School of Business, University of Regina. His research focuses on marketing, strategy, and innovation. He has published over 20 peer-reviewed articles in top management journals including Journal of Small Business Management, Research-Technology Management, and Journal of Business Strategy. His research has been featured in the National Post and by the World Economic Forum. Dr. Wilson is also a research consultant and contributor to Avenue Living Asset Management.

Mr. Jogia is the Chief Investment Officer at Avenue Living and has over 15 years of experience in real estate capital markets, originating over $10 billion in real estate loans and $1 billion in equity. He has extensive experience in real estate investment analysis and capital structure across various real estate classes. In addition to holding 2 Masters’ degrees in Finance, Mr. Jogia is pursuing his Doctorate of Business Administration and currently serves as an instructor at the University of Calgary, specializing in real estate finance.

INTRODUCTION

Diversification is synonymous with “not putting all your eggs in one basket.” If the basket drops, all of the eggs break. Therefore, placing eggs in multiple baskets – the act of diversifying – reduces such risk. The concept of diversification has a long history in finance and portfolio management (Markowitz, 1952). Diversification is a strategy that aims to reduce risk through the inclusion of multiple and differing investments. “The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security” (Segal, 2021). This paper first explores modern portfolio theory, the mechanics of how diversification reduces risk. Next, it examines the importance of diversifying portfolios with real estate investments and diversification within real estate portfolios for institutional investors. Last, the paper explores the limitations of diversification and advantages of specialization for small real estate owners/operators. It concludes by offering strategic directives for real estate investors.

MODERN PORTFOLIO THEORY

Developed 70 years ago by economist Harry Markowitz, modern portfolio theory can hardly be considered “modern.” Despite its age, modern portfolio theory’s relevance is timeless, as it offers a framework for designing portfolios that maximize return and minimize risk (McClure, 2021). According to Markowitz (1952), an investment’s risk comprises systematic and unsystematic risks. “A systematic risk is one that influences a large number of assets, each to a greater or lesser extent” (Ross et al., 2007). Systematic risks are also called market risks (e.g., recession) and cannot be eliminated by diversification (McClure, 2021). Conversely, “an unsystematic risk is one that affects a single asset or small group of assets” (Ross et al., 2007). Unsystematic risks are also known as asset-specific risks (e.g., supply shortage of a company’s input) and can be reduced through diversification. Markowitz (1952) argues that overall portfolio risk can be reduced to a certain point by diversification, as the inclusion of investments that do not move proportionally in the same direction at the same time eliminate unsystematic risk (Figure 1).

FIGURE 1 – MODERN PORTFOLIO THEORY

Sources: McClure (2021), & Ross et al. (2007)

Although modern portfolio theory was quickly and heavily embraced in the stock and bond markets, its application to real estate was much slower (Viezer, 2010). Only in the 1980s were diversification and modern portfolio theory applied to real estate. Today, savvy investors both diversify portfolios to include real estate and diversify within real estate investment portfolios.

DIVERSIFYING WITH REAL ESTATE

Miles and McCue (1984) were the first to show that real estate investments were significantly correlated with inflation, providing support for real estate as an investment hedge. Miles and McCure’s (1984) findings are highly relevant today, as recent examinations show that capital appreciation of real estate assets outpaces inflation (Wilson, 2021). Researchers have also shown that real estate investments have low correlations with stocks and bonds (Miles & McCue, 1982; Miles & McCue, 1984; Robichek et al., 1972; Viezer, 2010; Zerbst & Cambon, 1984), making them ideal for diversification (Markowitz, 1952; Ross et al., 2007).

The question of how much real estate to include in an investment portfolio has been widely debated (Firstenberg et al., 1988; Fogler, 1984; Giliberto, 1992; Hartzell, 1986; Irwin & Landa, 1987; Kallberg et al., 1996; Webb et al., 1988; Webb & Rubens, 1987; Viezer, 2010; Ziobrowski & Ziobrowski, 1997). Hartzel (1986) recommended smaller real estate investment allocations, such as 3% to 11%. Kallberg et al. (1996) and Giliberto (1992) offered similar recommendations of 10%. Firstenberg et al. (1988), Folger (1984), and Irwin and Landa (1987) argued that portfolios required 15% to 20% of real estate investments to achieve maximum diversification benefits. Ziobrowski & Ziobrowski (1997) concluded that 20% to 30% of an investment portfolio was necessary to realize the greatest return. Others have suggested that the majority of one’s portfolio should be comprise of real estate investments (Webb et al., 1988; Webb & Rubens, 1987). Despite the contrasting empirical evidence, research overwhelmingly supports the inclusion of real estate in portfolios to reduce risk and increase return (Viezer, 2010).

To illustrate, an examination of changes to home prices, land values, stocks, and bonds illustrates the benefits of Canadian real estate (Figure 2).

FIGURE 2 – ANNUAL CHANGES TO CANADIAN REAL ESTATE, STOCKS, & BONDS

Sources: Bank of Canada (2022), Farm Credit Canda (2021), Statistics Canada (2022), Yahoo Finance (2022)

The new house price index – a measure to assess changes to home prices in Canada – has shown consistency and strong year-over-year appreciations, particularly from 2019 to 2021 (Statistics Canada, 2022). Annual changes to Canadian farmland values have also been favorable and consistent, ranging from 4% to 8% in the period examined (Farm Credit Canada, 2021). In contrast, the S&P/TSX composite – the benchmark Canadian stockmarket index – has shown double-digit returns but also extreme volatility from 2016 to 2021 (Yahoo Finance, 2022). Over the last several years, Canada’s 10-year government bond has offered stability, but at the expense of nominal returns (Bank of Canada, 2022).

The risk and return benefits of real estate – demonstrated by past empirical examinations and in the above depiction – emphasize the need to include real estate in investment portfolios for diversification. According to Viezer (2010), “first decide the optimal allocation of real estate to a multiasset portfolio, and then decide how to diversify within the real estate portfolio.”

DIVERSIFYING WITHIN REAL ESTATE

Researchers have debated the most effective means to diversify real estate portfolios, as unsystematic risk can be reduced by property type, geographic, and financial diversification (Anderson et al., 2015; Benefield et al., 2009; Campbell et al., 2003; Cici et al., 2011; Cronqvist et al., 2001; Gobbi & Sette, 2014; Gyourko & Nelling, 1996; Hartzell et al., 2014; Ioannidou & Ongena, 2010; Ro & Ziobrowski, 2011; Santos & Winton, 2008).

According to Miles and McCue (1982), property type diversification offers the greatest return and the lowest risk. This has been replicated in studies of real estate investment trusts (REITs). Benefield et al. (2009) and Row and Ziobrowski (2011) show that diversified REITs outperform specialized REITs. Anderson et al. (2015) corroborate these findings, showing that diversified REITs have a “strong positive relationship” with return on assets, return on equity, and Q ratios (market value to asset replacement cost). Anderson et al. (2015) explain that “the diversification benefit comes from both the ability to select better-performing property types in ‘hot’ markets and the limited exposure to poorly performing property types in ‘cold’ markets” (p. 48). In addition to property type diversification, diversifying with private or public REITs has its advantages. According to Blackstone (2022) and Wang (2021), private REITs generally increase in times of rising interest rates and have less volatility, as compared to public REITs. As such, unsystematic risk can be reduced by REIT type (e.g., public/private) and property type (Gyourko & Nelling, 1996).

There is a significant body of research that shows the benefits of geographic diversification (Campbell et al., 2003; Cici et al., 2011, Cronqvist et al., 2001; Feng et al., 2021; Hartzell et al., 2014; Jud et al., 2021; Oertel et al., 2019). Hartzell et al. (1987) argued that diversification based on geography was strategic, given the performance benefits. As with property type diversification, geographically diverse REITs have been shown to outperform geographically concentrated REITs. According to Feng et al. (2021), “geographic diversification is associated with higher REIT values for firms that can be described as being more transparent” (p. 267). Recent work by Jud et al. (2021) and Oertel et al. (2019) adds to such geographic diversification research, showing international acquisitions offer enhanced portfolio returns.

Grissom et al. (1987) acknowledged the performance benefits of diversifying by both property type and geography. In fact, this research showed that diversification “across markets and property type reduced unsystematic risk more than across just markets or across just property types” (Viezer, 2010). Accordingly, Grissom et al.’s (1987) research supported the combination of property type and geographic diversification to reduce risk and increase returns. A lesser-explored area of research suggests that financial diversification may also reduce unsystematic risk among real estate investments.

There is an inherent risk in concentrated borrowing. According to Gobbi and Sette (2014), in times of crisis concentrated borrowing is detrimental to a firm’s access to credit. Moreover, Ioannidou and Ongena (2010) find that interest rates increase for clients over time and companies can negotiate better deals in new relationships with different banks. Therefore, it is strategic for real estate companies to diversify their borrowing to reduce unsystematic risk and negotiate better interest rates.

It is evident that diversification with and within real estate (e.g., property type, geography, and financial diversification) is necessary to maximize returns and minimize risk, but can endless diversification reintroduce risks?

OVER-DIVERSIFICATION & SPECIALIZATION

When strategically executed, diversification is a proven method to reduce risk and increase return (Allison, 2021). However, it is possible to over-diversify. Investments that are not strategically motivated are unadvisable (Olgun, 2005), as they add unnecessary risk to the portfolio without the added upside (Allyson, 2021). Lynch (1989) coined this phenomenon of worsening the risk and return tradeoff of an investment portfolio by over-diversifying as “diworsification.” This paper argues that the real estate diversification and performance relationship is curvilinear, similar to other strategies (Bhuian et al., 2005; Oswald & Brettel, 2017; Tsai et al., 2008). While diversification is necessary to reduce risk and increase return, beyond a certain level it can become detrimental to portfolio performance (Figure 3).

FIGURE 3 – DIVERSIFICATION & PERFORMANCE RELATIONSHIP

Diversification is also not advisable for new or small owners/operators. According to Kenton (2022), a specialization strategy focuses on limited scope and expertise for greater efficiency and performance. Specialization has been shown to create economies of scale, improve market positions, and enhance the bottom line of small businesses (Intihar & Pollack, 2012; Williams et al., 2018; Wilson et al., 2020). New or small real estate owners/operators are more likely to benefit from a specialization versus diversification strategy, as eliminating unsystematic risk is unlikely due to the small number of properties, geographic concentration, and individual property management. As these new and small owners/operators mature and expand, a diversification strategy becomes more advantageous and reduces their accumulated unsystematic risk.

STRATEGIC DIRECTIVES

So how much real estate diversification is enough, and how much is too much? Diversification with and within real estate is necessary for investors. However, Olgun (2005), aptly states that non-strategic real estate investments are problematic and often produce “negative abnormal returns.” Instead, when real estate investments are strategically included in multi-asset portfolios they increase return and reduce unsystematic risk (Miles & McCue, 1982; Miles & McCue, 1984; Robichek et al., 1972; Viezer, 2010; Zerbst & Cambon, 1984). Diversification within real estate is also required to eliminate unsystematic risk and realize the greatest level of return (Grissom et al., 1987; Hartzell et al., 1987; Jud et al., 2021; Miles & McCue, 1982; Oertel et al., 2019, Viezer, 2010). As Grissom et al. (1987) suggest, the best results come from combined diversification methods (e.g., property type and geography). It is further argued that financial diversification can also help reduce unsystematic risk and lower borrowing costs. In the context of Canada, investment portfolios that include residential real estate and farmland as core assets appear to both enhance value and offer stability. Diversification within these real estate investment categories, such as the types of residential real estate and various Canadian sub-markets, are also likely to enhance the overall portfolio of investors. As Peter Bernstein, one of the most prominent American economists wrote, “diversification of risk matters not just defensively, but because it maximizes returns as well, because we expose ourselves to all of the opportunities that there may be out there.”

 

 

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This commentary and the information contained herein are for educational and informational purposes only and do not constitute an offer to sell, or a solicitation of an offer to buy any securities or related financial instruments. This article may contain forward-looking statements. Readers should refer to information contained on our website at www.alamstg.wpenginepowered.com for additional information regarding forward-looking statements and certain risks associated with them.

Authors

Grant Alexander Wilson, Ph.D., Assistant Professor, Faculty of Business Administration, University of Regina

Jason Jogia, MBA, M.Fin., Chief Investment Officer, Avenue Living

Author Bios

Dr. Wilson is an Assistant Professor at the Hill and Levene School of Business, University of Regina. His research focuses on marketing, strategy, and innovation. He has published over 20 peer-reviewed articles in top management journals including Journal of Small Business Management, Research-Technology Management, and Journal of Business Strategy. His research has been featured in the National Post and by the World Economic Forum. Dr. Wilson is also a research consultant and contributor to Avenue Living Asset Management.

Mr. Jogia is the Chief Investment Officer at Avenue Living and has over 15 years of experience in real estate capital markets, originating over $10 billion in real estate loans and $1 billion in equity. He has extensive experience in real estate investment analysis and capital structure across various real estate classes. In addition to holding 2 Masters’ degrees in Finance, Mr. Jogia is pursuing his Doctorate of Business Administration and currently serves as an instructor at the University of Calgary, specializing in real estate finance.

INTRODUCTION

The inflation example of milk increasing from $0.40 to $4.00 per gallon over a 100-year period (Wilson, 2021a) requires an update, as milk prices are expected to increase by a record-breaking 10% in 2022 (Canadian Broadcast Company, 2021; Heslop, 2021). Inflation is the increase of prices (e.g., milk), resulting in decreased purchasing power of consumers (e.g., milk buyers) (Lumsden, 2011). The primary explanations of inflation are demand-pull and cost-push (Lumsden, 2011). Prices of goods and services appreciate as a result of increased aggregate demand (demand-pull) or the rising production costs (cost-push) of such items. According to Pride et al. (2020), a stable rate of inflation is 2% per annum.

The most common measure of inflation is the change to the Consumer Price Index (CPI) (Statistics Canada, 2021a). The CPI “measures price change by comparing, through time, the cost of a fixed basket of goods and services” (Statistics Canada, 2021a). Prior to COVID-19, annual changes to the Canadian CPI averaged just below 2.0% (Figure 1). Canada’s pandemic-induced economic contraction and unemployment increase, resulted in unprecedentedly low inflation in 2020. With the rollout of vaccines in 2021 and the full reopening of the economy, Canada is now experiencing above-average inflation. This trend is likely to continue, with high inflation forecasted into 2022 and beyond (Trading Economics, 2021a) (Figure 1).

FIGURE 1 – 12-MONTH CPI CHANGE & FORECAST

Statistics Canada (2021b) & Trading Economics (2021a)

Although inflation is a country’s natural economic tendency (Rothbard, 1962), if prices increases too quickly and without corresponding wage changes, purchasing power is diminished (Pride et al., 2020). Over the last five decades, industrialized nations’ monetary policies have placed great emphasis on the prevention and reduction of inflation (Lumsden, 2011). However, such policies are imprecise, much less guaranteed. Accordingly, savvy investors have explored ways to hedge against inflation. Specifically, multi-family residential real estate investments are increasingly appealing for investors (Nickerson, 2021). The next sections describe how forecasted interest rates, home values, and energy prices support the investment in multi-family properties.

INTEREST RATES & AFFORDABILITY

According to the Bank of Canada (2021a), it “carries out monetary policy by influencing short-term interest rates. It does this by adjusting the target for the overnight rate.” In an attempt to stabilize the economic contraction from the pandemic, the Bank of Canada (2021b) decreased the overnight rate from 1.75% to 0.25% in early 2020. As Canada’s economy expands and high inflation looms, the Bank of Canada is expected to increase the overnight rate by 1.25% to 1.50% by March 2023 (Trading Economics, 2021b) (Figure 2).

FIGURE 2 – CANADIAN OVERNIGHT RATE & FORECAST

Bank of Canada (2021b) & Trading Economics (2021b)

According to the Bank of Canada (2021c) the overnight rate is the starting point for “interest rates in the economy that matter for Canadians.” Changes to the overnight rate result in corresponding changes to commercial lending rates (Kenton, 2021). Based on the forecasted overnight rate and resulting commercial lending rate changes, mortgage interest rates are likely to increase by 1.25%. Table 1 illustrates the homeownership affordability effects of a 1.25% interest rate increase across various home values ($350,000 to $1,000,000), assuming a 5% down payment, 4% Canadian Mortgage and Housing Corporation (CMHC) insurance premium, 25-year amortization period, and 12 payments per year.

TABLE 1 – MORTGAGE PAYMENTS & INTEREST RATE CHANGES

 

*2.25% IR = 2.25% interest rate, **3.5% IR = 3.50% interest rate

            The change of 1.25% in mortgage interest rates elicits an increase of 14.8% in monthly payments. Given over 25% of Canadian homeowners currently spend more than what is considered “affordable” on mortgage payments (Canadian Mortgage and Housing Corporation, 2018; Statistics Canada, 2019), the planned interest rate increases will create further affordability issues. Specifically, there will be heightened barriers to entry for new home buyers and greater risk exposure for variable-rate mortgage holders. As a result, the rental market is increasingly appealing to middle-income earners (Wilson, 2020). The growing rental demand is also appealing for real estate investors, as more renters mean lower vacancy rates and stronger cash flows. Individuals and property investors with fixed interest rates will be advantaged over those with variable rates. Individuals will be better able to manage their household budget and property investors can increase residential rents – in accordance with the tenancy agreements – in response to interest rate changes.

HOME VALUES & AFFORDABILITY  

As with interest rate increases, the appreciation of home values in Canada has created affordability issues for housing market participants. Since the onset of the pandemic, Canadian home prices have appreciated significantly (Figure 3). Home prices increased by nearly 20% from October 2020 to October 2021. The new housing price index – a proxy for residential property appreciation – is expected to continue to increase in 2022 and plateau well above pre-pandemic values.

Statistics Canada (2021c) & Trading Economics (2022)

The appreciating nature of residential real estate, including single and multi-family dwellings, is both promising for investors and challenging for new home buyers. According to Wilson (2021a; 2021b), capital appreciation from property investments has historically outpaced inflation, proving to be an effective hedge. In contrast, the wages of low and medium-income earners lag market price changes (Shahid, 2021), making homeownership increasingly difficult. Aside from the rising home prices and impending interest rate increases, the energy market outlook poses new affordability concerns.

ENERGY MARKET & AFFORDABILITY

After 18 months of natural gas supply shortages caused by the pandemic and its increased demand due to the reopening of the global economy, prices have surged to new heights (Figure 4). Average natural gas prices are expected to track above $5.00 per Metric Million British Thermal Unit (MMBtu) for the foreseeable future. These increases “will fuel inflation and hit low-income Canadians the hardest” (Alini, 2021).

  FIGURE 4 – NATURAL GAS PRICES & PROJECTIONS

Investing (2021) & Trading Economics (2021d)

            As natural gas is the main source of energy that heats homes and businesses (Canadian Gas Association, 2020), Canadians will be impacted both directly and indirectly by price increases. Natural gas prices will directly impact most Canadians’ utility bills, making homeownership less, and renting more, desirable. The indirect effects of natural gas price increases are realized by consumers via cost-push inflation. For example, higher energy costs make it more expensive to produce, transport, and store goods, resulting in higher-priced goods and services. The energy market outlook makes renting an affordable or in some cases a necessary, alternative to homeownership. From a real estate investor perspective, the natural gas market outlook and its inflationary pressures are poised to create strong demand for residential real estate, further supporting low vacancy rates that translate into consistent cash flows.

INSIGHT FOR INDIVIDUALS & INVESTORS

The multi-family residential real estate market is ideal for individuals and investors amid high inflation, increasing interest rates, soaring home values, and energy price forecasts. For middle-income individuals and families, these market uncertainties support renting in the short term. For investors, the capital appreciation from increasing property values and consistent cash flow from the high rental demand support investment positions in multi-family residential real estate.

STRATEGIC INVESTMENT IN MULTI-FAMILY REAL ESTATE

It is well documented that real estate has historically outpaced inflation (Wilson, 2021a; 2021b). Accordingly, investments in real estate have been regarded as a strategic hedge against inflation. However, based on the current market outlook, residential real estate has advantages over commercial real estate investments. As discussed, rising inflation, interest rates, and natural gas prices are making homeownership increasingly difficult for many Canadians. Strong demand for rental housing is imminent, affording residential real estate investors strong cash flows due to low vacancy rates. Commercial renters – producing goods and services – are not immune to inflationary pressures, as operation costs are continually increasing. In many cases, these costs are passed down to the consumer, but not always. The pandemic and its lagged effects created some of the highest commercial vacancy rates on record (The Canadian Press, 2021). Despite the recent declining trend in commercial vacancy rates across Canada – due to the reopening of the economy – changes are less immediate and rates are far greater than in the residential market (The Canadian Press, 2021). Lastly, residential, as compared to commercial, leases allow for more flexibility. Residential leases are short-term, ranging from month-to-month to 12-month contracts. Conversely, commercial leases are conventionally five-year terms. The flexibility of such short-term contracts permits greater responsiveness to inflation and interest rate changes, advantaging residential real estate investors.

CONCLUSION

Rising inflation, increasing interest rates, and soaring natural gas prices are working against the proverbial homeownership dream in Canada. The re-examination of real estate’s effectiveness as an inflation hedge is upheld and supports previous work (Wilson, 2021a; Wilson, 2021b). However, current market dynamics advantage residential versus commercial estate in the short and medium term. Consequently, investments in multi-family properties are likely to be both strategic and profitable.

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