Sector diversification

Sector diversification will require agility, creativity and time

A significant shift in real estate sector strategies is underway.

Portfolio strategies had already been shifting during the decade leading up to the COVID-19 era, when pressures on retail and office performance began to benefit allocations to the industrial, living and alternative sectors. With that said, the extent of shifts to-date have differed around the world, given varied sizes of the investible universe, varied performance and contrasting forecasts across cities and sectors.

The scale and transparency of the US market allowed funds to pivot and diversify to a greater extent over the past decade. However, the steady maturation of the investible universe in European and Asian markets has triggered diversification for active groups globally, to a greater extent, over the past five years. As a proxy for institutional markets, the extent of shifts is evident when analyzing the Global ODCE index and its component indices across the regions:
 

• The living sector is now the largest investable real estate sector globally. We are currently seeing a strong focus from capital on the multifamily / build-to-rent, student housing and single-family rental sectors. Over the next five years, $1.4 trillion is expected to be deployed into living strategies globally. By 2030, JLL expects one-third of annual real estate investment to occur in the living sector.
• The logistics sector also remains in focus, with strong demand for the sector from occupiers and investors, as well as meaningful innovation and growth in the outlook for manufacturing, e-commerce and urban logistics to varying degrees around the world.
• Collective exposure to logistics and living has increased significantly for the largest core funds globally, increasing by $139 billion since 2016 and having grown at an annual rate of 10 - 13% globally over this time period. These sectors now account for around 63% of core fund exposure in the US, 53% in Asia Pacific and 47% in Europe.
• Over the same period, there has been a net outflow of $4 billion from the retail sector across these funds, to the greatest extent in 2019 and 2020. Global aggregate allocations to retail as a result have decreased by 11% since 2016 across the core funds.
• The office sector has been a significant anchor for these funds in recent decades. This notably shifted from 2020, where a combination of weakened global sentiment, declines in valuation and strategic dispositions decreased exposure across these funds by 17%. This is most pronounced in the US, where the aggregate allocation across these funds decreased from 35% in 2020 to 18% as of Q2 2024.

Reallocation of capital in its early stages given prolonged volatility and deployment hurdles

The market is consequently still in the early stages of a significant reallocation of capital, and it will take time. However, sector diversification will remain a critical benefit and risk mitigant, both across and within sectors. Diversification will take different forms in markets around the world, and even those sectors which are currently "out of favor" still have a place in global, diversified portfolios.

However, higher interest rates and an uncertain global economy have made current portfolio aspirations difficult to execute today. Current market volatility will stall diversification progress through 2024. In the near-term, investors will take a ‘step back’ in order to weather the storm and ‘step forward’, challenged by near-term liquidity needs which do not necessarily align with long-term portfolio goals. However, opportunistic sectoral diversification is already happening, in particular for alternative strategies – even at scale in the current climate, reinforcing its priority for capital.

The biggest challenge to portfolio managers is, perhaps, the future of office holdings, faced by constrained liquidity and valuation declines amid weaker global sentiment and uncertainty of future demand. Global office vacancy as of Q2 in 2024 was 16.7%, up from 12.5% at the end of 2020. Today, investors and lenders are both focused on existing office exposure, identifying those strategic and non-strategic assets and exploring alternatives to right-size office holdings.

There are still many unknowns, as uncertainty persists. The extent – both in duration and depth – of the current correction and pace of recovery will impact the extent of sector rebalancing.

And deployment will be a hurdle, given varied degrees of barriers to entry, competition and crowding-in strategies. Agility in strategy and real-time connectivity to market activity will be critical. On the other side of the storm, both institutional and private investors will find opportunities, and those opportunities will be in income- as well as growth-oriented strategies across the full spectrum of sectors.