When It Comes to Real Estate Investing, Not All Sectors are the Same

As a financial professional, you continually assess the market landscape to determine the best moves for your clients. One area you might have shied away from is commercial real estate, as headlines have been anything but quiet about the asset class’s recent challenges.

However, painting a broad brush of valuation declines across all property types may be misleading. In fact, now could be an opportune time to reallocate to real estate, especially when done through a thoughtful sector rotation.

A Dose of Perspective: The Decline of Key Sectors

Institutional managers who track private real estate have relied on NCREIF (National Council of Real Estate Investment Fiduciaries) and its NFI-ODCE Index for over 40 years to monitor the property valuations of the largest sectors - primarily office, retail, industrial, and apartments.

The big four have certainly experienced a pricing reset from peak to trough through Q1 2024, confirming what headlines have been saying for the past 18 months.

Private Real Estate Sector Valuation Performance⁷

(Peak to Trough Through Q1, 2024)

Private-Real-Estate-Sector-Valuation-Performance-Chart

Source: IDR, NFI-ODCE. Cumulative peak-to-trough valuation change calculated using gross property level unlevered appreciation by property type as of 1Q 2024. Past performance is not a guarantee of future results. Presented June 18, 2024 at the NFI-ODCE Index First Quarter Update – What’s Changing and What’s Not webinar produced by Institutional Real Estate, Inc. and IDR Investment Management

If these valuation declines want to make you want to turn and run from a real estate strategy, it’s important to recognize that spikes and declines in property valuations are a natural part of the real estate cycle. The current valuations may be an indicator that we are in the late stages of the cycle with several sectors poised for recovery and potential expansion.

Also, it’s important to keep in mind that the decline in performance of some traditional sectors are not reflective of the performance of all sectors. Frankly, compared to the Great Financial Crisis where all property types were impacted, the current drawdown appears to be quite manageable.

Great Financial Crisis vs. Current Drawdown⁷

(Historical Drawdown - Net Total Returns)

Great-Financial-Crisis-vs-Current-Drawdown

Source: IDR, NFI-ODCE Index. GFC Q0 = 2Q 2008. Current = 3Q 2022. Drawdown based on net total return as of 1Q 2024. Presented June 18, 2024 at the NFI-ODCE Index First Quarter Update – What’s Changing and What’s Not webinar produced by Institutional Real Estate, Inc. and IDR Investment Management

Time for Sector Rotation

If your clients’ portfolios hold one or more of the big four property types, you may want to consider rotating your allocations to several demand-driven sectors. These sectors haven’t experienced the same types of losses and are likely to see full recovery and quicker growth.

In fact, demand for these lesser-known sectors has grown among institutional investors to the point where NCREIF has now included them as key components of the big four (highlighted in yellow).

New NFI-ODCE Asset Class Definitions and Components⁷

Big-4-NCREIF Source: IDR, NFI-ODCE Index. Estimate of property type diversification by NPI categorization as of 1Q 2024. Presented June 18, 2024 at the NFI-ODCE Index First Quarter Update – What’s Changing and What’s Not webinar produced by Institutional Real Estate, Inc. and IDR Investment Management

Combined with self-storage and senior housing which NCREIF lists as sectors in the “other” category, there are a range of commercial property types you may not have considered but should investigate.

Rotating to Demand-Driven Sectors

While these sectors each have their own unique characteristics, collectively, they stand apart from the large traditional property types due the strong demand-drivers that point to the opportunity for stability and consistent growth. Several of these non-traditional real estate sectors have shown resilience and performed relatively well compared to traditional sectors such as office and retail, which experienced declines throughout 2023 and into 2024. Here’s a snapshot of each:

Manufactured Housing

Manufactured housing has exhibited solid performance and stability compared to other real estate sectors. This sector is characterized by several key strengths that contribute to its potential for growth and resilience, including high occupancy rates reaching 94.7% by the end of 2023. Additionally, rents for manufactured housing have continued to grow, with an average increase of 7.3% year-over-year and 10.1% rise in the South.¹

Self-Storage

Self-storage has steadily evolved from a once-niche market 20 years ago to a growing and resilient sector, performing well throughout all stages of the market cycle. Many investors view self-storage as a great diversifier helping to hedge against economic downturns. The sector benefits from consistent demand drivers including dislocation, downsizing, and divorce. In fact, self-storage has been a top-performing asset class across the REIT universe for more than the last 20 years.² Despite a current oversupply of inventory, self-storage is expected to provide the consistent returns investors expect.

Student Housing

Student housing has also shown strong performance, driven by high occupancy rates and robust rent growth. Despite economic volatility, the sector has attracted a significant amount of foreign and private capital. New bed deliveries have decreased, but the demand remains strong, resulting in an expected 8% rent growth for the upcoming 2024/2025 academic year. This resilience is partly due to the sector's ability to maintain stable income even as financing costs rise.³

Medical Outpatient

The medical outpatient sector remains attractive due to its stable demand, driven by an aging population and the ongoing need for more accessible and local healthcare services. This sector has experienced less volatility compared to traditional office spaces. The demand for medical outpatient space is supported by long-term leases and essential services,⁴ which may provide a stable income stream for investors.

Senior Housing

Senior housing has shown positive momentum, with occupancy rates improving steadily over the past nine quarters. The sector benefits from a growing aging population and limited new supply, which helps maintain high demand. However, financing and development challenges persist, particularly for affordable senior housing. Public-private partnerships and government incentives are increasingly crucial in addressing the need for more affordable options in this sector.⁵

For clients who hold or have held real estate in their portfolios, this appears to be an opportune time to rotate real estate allocations. Real estate remains the third-largest asset class globally,⁶ and as you know, serves an important role in a well-diversified portfolio, even as the asset class progresses through the late stages of the real estate cycle.

By reallocating to sectors with robust demand drivers, you can craft a strategy with potential growth and recovery. Embrace sector rotation thoughtfully, leveraging the unique strengths of non-traditional property types to maximize returns. Real estate, with its recovering landscape, continues to offer valuable opportunities.