Real estate investor portfolio allocation strategies

Managing investor capital flexibility and understanding the impacts of the denominator effect

On top of global market uncertainty and increasing redemption requests, impacts of the denominator effect could further hinder real estate investors’ agility with their portfolio balancing decisions. For investors seeking guidance in this complex environment, our report presents real estate portfolio management strategies to consider in the year ahead.

The phenomenon driving outsized real estate exposure

Institutional investor confidence is waning as the convergence of economic uncertainty, geopolitical risk, and elevated inflation and interest rates batters resolve and drains returns.1 The past year notched an unusual phenomenon, the simultaneous decline of both global equities and bond markets, though the real estate sector in particular exhibited some retained momentum, still notching positive annual returns despite a down second half.

Figure 1. Annual investor returns by sector

For fund and investment managers, strict governance and target portfolio allocation policies are generally put in place to create transparency for investors, aligning their investment criteria with those of the institutional vehicles in which they are participating. These allocation policies can also provide further clarity on diversification strategies, disclosing both targeted and actual portfolio exposure to assets such as equities, fixed income, private equity, or real estate.

Volatility in public and private markets in 2022 caused unintended shifts in institutional investor portfolio compositions and is not necessarily representative of improper investment decisions. This has led to a concept coined the “denominator effect,” which has become a reality for many investors exposed to real estate.6

What is the denominator effect?

  • It occurs when valuations of certain portfolio assets fluctuate considerably, in turn moving the bottom-line valuation of the overall portfolio.
  • When overall portfolio values decline except for one asset class (in this case, real estate), that asset class can inadvertently end up overweighted.
  • For example, in the California Public Employees Retirement System (CalPERS) performance summary presented at the November 2022 meeting of the Investment Committee of the Board of Administration, it was noted that as of September 30, 2022, the fund was 3.7% over the interim strategic asset allocation target of 13.4%. This overweight is still within the asset allocation target and range parameters set by the CalPERS Board. Fiscal year-to-date performance for real assets was noted as 2.8%, the only asset class with positive absolute performance for the period.7

Portfolio returns coupled with the denominator effect and a rush of investor redemptions to limit their exposure to overall markets8 have likely contributed toward a sizable uptick in investors who are both overallocated to their real estate targets or are increasingly nearing their policy guidelines. This increase exists despite a general slowdown in capital deployment and nearly 30% year-over-year declines in direct real estate investment activity.9

Measuring the crunch

Using data supplied by alternative assets data provider Preqin, the Deloitte Center for Financial Services measured the impact of the previously described recent market developments on portfolios across a sample of real estate investors. This would allow us to measure investor flexibility and could offer insight on how investors stack up against their peers and how they can better prepare for the next phase of this cycle.

We analyzed the actual and target real estate allocations captured by Preqin over the span of the past four years for more than 1,500 firms, adding some historic context from before the pandemic. These firms represent global investors from 67 countries across 18 different investor classes, such as asset managers, endowments, insurance companies, and public and private pension funds, among others. These investors have nearly $23 trillion in total assets under management, with over $1.7 trillion allocated to real estate.

According to differences between current and target allocations of the investors sampled, approximately 33% of real estate investors are now over their policy targets, up 11% from the 22% who were measured as overallocated last year and 6% over the 27% overallocated in 2019. For those still under target, the gap is shrinking substantially and currently sits at the tightest differential over the past four years—only 0.6%, or $92 billion available for deployment (figure 2). In dollars, this is a 68% decline in capital flexibility from last year at $286 billion. This was the case across the spectrum of investor types and most predominantly for private- and public-sector pension funds, which recorded 80- and 120-basis-point (bps) compressions from last year, respectively, down to 0.5% and 0.4%.

Figure 2. Difference between current and target allocations, by select investor type

How are investors approaching tightening flexibility?

Despite this compression through the end of 2022, some institutions have more recently enacted initiatives and revised their real estate investment strategies to further increase target limits and maintain their real estate commitments.10 Target allocation limits of our analyzed data sample funds increased by 70 bps last year to, on average, 9.9% of portfolio exposure to real estate—well behind the 150 bps increase in actual exposure, now up to 9.3%.

The appetite for long-term, high-yield alternatives such as real estate in the current market seems to align well with the overall long-term investment horizons of their contributors, institutional capital, and high-net-worth individuals alike.11 Even with some nearing the upper end of their policy ranges (often within three to five percentage points from target), there are examples of investors looking to further increase their allocations in 2023 and beyond, especially in the strained pension fund space:

  • California State Teachers’ Retirement System (CalSTRS) lifted its real estate target allocation from 14% to 15% in July 2022 in line with the fund’s long-term plan. The fund confirmed $1.34 billion worth of additional commitments into the sector going forward during their meeting in August.12
  • Ohio Public Employees Retirement System increased its real estate allocation from 10% to 12% for 2023. The pension fund noted its increase was to better hedge against inflation and enhance returns through diversification into a more opportunistic allocation strategy.13
  • Texas Municipal Retirement System outlines its 2023 real estate pacing plan. The US pension fund plans to invest an additional $500 million into real estate in 2023. The firm’s current allocation to real estate stands at 13.5%, already above its 12% target.14

Real estate investor strategy considerations

For investors seeking strategic guidance as they approach balancing their portfolio real estate exposure for the year ahead:

  • Now may be the time to consider supplementing core strategies by taking advantage of repricing opportunities in higher-yielding value-add or opportunistic strategies. The same can be said for property type focus—consider that drivers of yield in the past, core offices in particular, could face significant headwinds. Industrial and multifamily assets, while potentially trading at a premium after months of outperformance, could offer greater stability backed by strong fundamentals should property valuations decline further. Alternatives such as life sciences, self-storage, and data centers could provide upside with less competition than one of the “big four” asset types, driven by potentially changing consumer demand patterns generated by the pandemic.
  • Redemption risk will likely persist, as potential market unpredictability may remain ever present. Investors could prepare for sales of the most liquid assets to help stem the tide in the near term; however, consider that redemption queues can flip very quickly. At 7%, queues are less than half of what they were during the Great Financial Crisis15—and they shifted from a 15% redemption line in 2009 to a 14% entrance queue by 2010.16
  • Investment fiduciaries increasing allocations to private markets (private equity, real estate, private credit) seeking higher returns in the near term should consider the need for frequent liquidity analysis or stress-testing of portfolios, especially for smaller and mid-sized funds. Private markets can be illiquid and generally opaque.
  • Real estate debt strategies can offer an alternative to direct investment should interest rates increase. Investors in real estate can rely on resilient cash flows and capital value preservation. A rising interest rate environment could help floating rate loans, and opportunities for refinancing and recapitalization may grow over the year.
  • Firms with additional cash on hand awaiting more market clarity could tap into an alternative route into real estate through direct asset debt opportunities. Institutional investors could serve as alternative lenders for building acquisitions, as capital availability remains tight with large traditional lenders (such as banks) pulling back further entering 2023.17
  • As competition for high-quality assets grows, past performance and fund manager credibility could hold greater importance than ever before. Leaders should consider commingled funds instead of separate accounts (teachers, state employees, state police) to offer centralized management of multiple investors’ assets.

With market volatility and uncertainty across the economy and real estate fundamentals, many institutions may be operating on the side of caution, waiting it out to see where prices and interest rates land. All the while, allocations could continue to rebalance due to denominator effects and redemption requests, further straining policy limits. Some investors, therefore, may not have the luxury of time. Institutions should consider steps to address flexibility for their real estate exposure, possibly increasing targets and further committing to the asset class in potentially more non-traditional methods or identifying key assets for liquidation to help reduce exposure and manage redemptions in the short term.

End notes

1 State Street Global Markets, State Street investor confidence index, January 25, 2023.
2 NCREIF, NCREIF open end diversified core equity 4q2022 detail report, accessed January 30, 2023.
3 Russell, Russell 3000 factsheet, accessed February 13, 2023.
4 Russell, FTSE All-World ex US Index factsheet, accessed January 31, 2023.
5 Bailey McCann, “Pension funds are sticking with bonds for the most part,” Pensions & Investments, February 13, 2023.
6 Nasdaq, “The denominator effect—How volatility in the public markets has impacted fundraising in the private markets,” August 2, 2022.
7 CalPERS, “CalPERS trust level quarterly update—Performance and risk,” September 30, 2022.
8 Evelyn Lee, “Deep dive: A private real estate sell-off is starting,” PERE, December 1, 2022.
9 Ibid.
10 Sergio Padilla, “Institutions’ target real estate allocations rising ahead of buying opportunities—study,” Pensions & Investments, November 21, 2022.
11 Preqin, “Pension funds investing in real estate,” Preqin Real Estate Spotlight, September 2016.
12 Neil Fernandes, “CalSTRS commits $1.34bn to real estate,” PERE, September 12, 2022.
13 Jon Peterson, “Ohio PERS lifts real estate allocation to 12%,” IPE Real Assets, January 20, 2023.
14 TMRS, TMRS board meeting agenda and materials, December 8, 2022.
15 Evelyn Lee, “Today’s big redemption queues are not a repeat of the past,” PERE, January 27, 2023.
16 John Gittelsohn, “Investors seek to pull $20 billion from core real estate funds,” Bloomberg, January 17, 2023.
17 Mark Heschmeyer, “Big US banks pull back on office and apartment lending,” CoStar, January 18, 2023.

This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this publication.

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