Volatility in the macroeconomy may be giving some investors pause, but it is in times like this  that the importance of diversification is reinforced. Real estate has served an important role in institutional investor portfolios for decades – in our latest In Conversation, ARA’s Sabrina Unger and Jay Butterfield discuss the role of real estate in portfolios today. 

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Sabrina Unger: Hello, and welcome to another installment of ARA In Conversation. I'm Sabrina Unger, Managing Director and Head of Research and Strategy at the firm, and I'm here with Jay Butterfield, who heads up Investor Relations. Jay, ARA has been an investment manager and fiduciary for investors in real estate for more than two decades. What have been the reasons that groups have invested in real estate over the years and how might that be changing?   

Jay Butterfield: Well, the reasons may have expanded over the last several decades, but what was relevant then is still relevant now in what has driven investors to our asset class. They're seeking stable and steady income to meet their funding needs through an asset class other than bonds.

SU: What are some of the more recent additions to the list of reasons investors might consider real estate that might have popped up even since the last cycle?

JB: One reason that's come back recently that we haven't had to deal with over the last several years is inflation. Investors look at real estate as a way of diversifying their portfolio, but also as hedging against inflation. Traditionally income and total return have shown a correlation to inflation, and investors find it advantageous to have real estate in their portfolio so that when inflation goes up, their total return goes up, as well. Maybe you can take us through that a little bit. 

SU: The short answer is that inflation makes all of the components that go into constructing a building more expensive. Steel, drywall, concrete, even the labor itself inherently becomes more expensive when that occurs. It also means that existing buildings are now more valuable, because if you had to replace them, now it's more expensive to do so. So that's one element of how inflation becomes sort of a positive corollary to real estate returns.

The other part of it is that if inflation is occurring because of strong demand in the economy, that typically translates to stronger demand for space. So we have an environment in inflation where there's less new supply being built because it's more expensive to deliver, demand is stronger, and that typically translates into stronger rent growth and net operating income.

So that's how both income and total returns for real estate increase when inflation increases. 

JB: You mentioned replacement costs as a driver of returns. Could you give us a real-life example of that? I don't think a lot of people know what replacement cost means. 

SU: I think a simple example is thinking about it from the perspective of: you buy a house as an investment, you rent the house to a young couple, and every month they write you the rent check. That steady check that you're getting every month is your income return –it’s that steady cash flow that a lot of pension plans orient towards real estate for. 

But in an inflationary environment where it becomes more expensive to build a house, that alone helps contribute to the value of your investment increasing. You start to see maybe there are houses around you that are now selling for more than what you bought your house for. That is inherently embedded appreciation, and so effectively the home is more valuable, and it's more expensive to replace, and that is effectively how replacement costs translate into higher returns during inflationary periods.

But I want to take us back to this idea of diversification. You mentioned this earlier as a reason investors have leaned into real estate and used that income as a diversifier, or potential replacement, for part of their bond portfolio. But thinking about how bonds have behaved in the most recent few years, does that alter how investors should be thinking about real estate in the broader context of their portfolios?

JB: You may remember that for a long time, bonds weren't really yielding anything in the post-Global Financial Crisis period – interest rates were effectively zero. Now, that's not the case today. During that period of time, investors looked towards real estate for that steady income with the possibility of appreciation with only slightly higher volatility.

Today, interest rates aren't zero. Investors are looking at real estate in a different light, with diversification as its own asset class. If you think about stocks and bonds, they're pretty much the same for all investors, but real estate is backed by physical individual properties. You and I might own a stock in a company, and if we own the same stock, we'd get the same return. For real estate, if I own an apartment building on the block over there, and you own another apartment building three or four blocks down, we might have totally different experiences with those two assets. 

Groups may also look at real estate as a diversifier for downside protection. So we saw that obviously in 2022 through 2024. Stocks and bonds have different returns than real estate. So over the last four decades, the average downside years for real estate are about negative 8.5 percent. Whereas for stocks and publicly traded real estate, REITs, it has been about 13 percent. In fact, the single worst year, real estate was negative 17 percent. For stocks, it was negative 37 percent. So making an investment in real estate, especially if you're thinking about protecting against the downside, might be a smart thing to do. 

Looking at that today in 2025, what would you say to investors perhaps, that are coming new to the asset class and making their first investments in real estate? What advice would you have for those who already have an allocation but perhaps are looking for a new direction or what next step to take? 

SU: I would say for groups that haven't historically invested in real estate in their plans, the first place that we typically recommend to start is looking is at a core allocation, and really determining what is the motivation behind adding real estate to your portfolio.

If the driver is an orientation to shore up your income returns and lessen your volatility or your risk, core allocations are always a good place to start. And that's typically where investors make their first investments in real estate. By definition, it is the least-risky flavor of real estate investment, and it provides a lot of those attributes that we have discussed. Steady income, the potential for appreciation and diversification from other investments in their portfolio. So that's a good place to start for groups that have no exposure to real estate. 

For the investors that already have their core allocations or have been investing in real estate for some time, it's a good approach at the start of a new cycle, which we believe we're in now, to really take a look at what is in your portfolio, what investments do you have exposure to today? The beginning of a new cycle may be a good opportunity to consider making changes if you're unhappy with the orientation of the portfolios you have exposure to and then leaning into opportunities to tactically add on some higher returning strategies.

Now, that does come with a commiserate level of higher risk, but there is the potential to lean into higher-returning strategies. And I think I've said this in the past, early cycle investing, particularly in closed-end vehicles, has historically yielded stronger relative returns than if investors waited for the mid-cycle part of the recovery.

I think there's an opportunity in today's environment for groups that already have real estate exposure to maybe consider adding some of those higher-returning, closed-end strategies around their core allocations. 

JB: Well, thank you. That's certainly given us a lot to think about as we enter a new phase of the real estate cycle.

I'm looking forward to talking to you in future In Conversations and talking about ways that our investors can benefit from investing in real estate.

This transcript of the ARA In Conversation discussion has been edited for clarity.

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Disclaimer

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