LOOK AHEAD 2023: Sector selection to have less impact on returns

Investing in favored sectors has strongly correlated with outsized returns in private real estate in recent years. In 2023, however, Chicago-based LaSalle Investment Management sees property type selection having far less influence as a key driver of performance than it had previously.

Historically, if a manager was overallocated by 10 percent to the best performing property types, it would gain about 50 basis points of relative outperformance for the trailing year relative to indexed performance, Richard Kleinman, LaSalle’s co-CIO and head of research and strategy for the Americas, told PERE. Last year, overallocation to the highest-returning sectors resulted in outperformance of over 400 basis points, he noted.

“In the US the last several years have been exceptional in the magnitude of impact that sector allocation has had on relative portfolio performance,” Kleinman said.  “The next several years will see a return to more normal conditions with sector allocation not as overwhelming a driver and market allocation and asset selection will again be important drivers of relative portfolio performance.”

For example, apartment returns last year spiked to contribute over 300 basis points of excess return for the trailing year in real estate. Going forward, however, Kleinman said a portfolio is likely to benefit more from an underweighting to struggling property types, like offices, rather than an overallocation to outperforming asset classes like before.

The growing importance of market selection

Market selection will arguably be the most important factor in real estate performance going forward, particularly in the US. The broadening base of investible markets in the largest real estate market in the world makes for more dispersion in returns, according to Kleinman.

That dispersion will be driven largely by differing supply and demand dynamics in US property markets. After new deliveries picked up during the latter half of the pandemic, industrial and residential supply is set to remain at healthy levels in 2023, but a weakening economy could limit new supply by 2024, Kleinman said. Limited new supply coupled with an anticipated economic recovery will in turn create high barriers to entry in some markets, he added.

Gaining footholds in markets where supply is set to be limited therefore becomes a major advantage. For multifamily, being in the right neighborhoods and school districts becomes a differentiator that can drive rents. In an emerging sector like self-storage, a local approach can be even more critical.

“People aren’t going to drive all the way across a market to store their stuff,” Kleinman said. “Looking at that, very local supply dynamics are important.”

Of course, property type selection and market selection can intersect. A broader range of investible markets in the US means that a portfolio can be more diversified by sector and by market. Kleinman noted that office – due to it once being the largest component of diversified portfolios – faces challenges now with assets that were built in secondary markets at the peak of the sector’s popularity.

Now, portfolios are more commonly dominated by industrial and residential properties, which LaSalle is comfortable owning across a broader set of markets. This is particularly the case in residential given that many secondary markets, like Orlando, Tampa and Phoenix, were seeing north of 20 percent rent growth earlier this year, according to Kleinman.

Indeed, even within a particular sector, the performance of an investment will vary depending on where the asset is located. For this reason, markets will matter more than ever in the year ahead, he said.