Diversifying With Real Estate and Infrastructure

Investing in something other than stocks and bonds is undoubtedly a significant element of asset allocation. Two optimal alternative investments are real estate (land and structures on it—real property, in other words) and infrastructure (vital physical networks that industries, individuals, and regions need, like transportation, communication, sewage, water, and electric systems).

Both real estate and infrastructure constitute attractive investments for risk-averse investors, especially during bear markets. There are similarities and differences between the two, and you can construct a truly optimal portfolio by fully exploiting them. 

Diversification Through Real Estate and Infrastructure

The diversification benefits of direct and indirect real estate investments are well known, and diversification's role in institutional portfolios has been investigated extensively. The different correlations to those of stocks and bonds are extremely helpful for avoiding portfolio volatility. Rental of residential real estate is a defensive sector. People will continue to rent their place of residence even if there is a recession or a depression.

Infrastructure has received relatively less attention, along with other alternative assets such as commodities and private equity, in the past. But with the Biden administration voicing its support for large infrastructure overhaul in the U.S., investors should take advantage of this potential to diversify more effectively than ever and in an extremely promising sector. In fact, infrastructure has become a focus of attention and found its way into institutional portfolios, and, to a lesser extent, private ones.

What makes infrastructure so appealing is that it seems quite similar to direct real estate in terms of big lot sizes and illiquidity, but also offers general stability and stable cash flows.

For the last 20 or 30 years, the area of investing in infrastructure had been the dominion of large pension funds and sovereign wealth groups. But now an increasing number of publicly traded companies are targeting this area, opening up investment options for individual investors. Real estate and infrastructure are often bundled together in securities such as real estate investment trust (REIT, master limited partnerships (MLPs), or mutual funds that target these particular sectors.

Portfolio Optimization With Real Estate and Infrastructure

From an asset-allocation standpoint, research on infrastructure lags behind that of real estate, but researchers Tobias Dechant, Konrad Finkenzeller, and Wolfgang Schäfers of the University of Regensburg International Real Estate Business School have attempted to bridge the gap (no pun intended). Their paper published in the Journal of Property Investment & Finance demonstrates that direct infrastructure investment is an important element of portfolio diversification and that firms tend to over-allocate to real estate if they do not also invest in infrastructure, which the authors consider a separate asset class.

There is considerable variation in the recommended, relative amounts that should be invested in real estate and infrastructure. The maximum total amount usually recommended for allocations is about 25% to 40% of total net worth. But the range extends from 10% to as high as 70% (mainly in real estate), depending on the time frame, state of the markets, and the methods used to derive the optimum. Efficient allocations in practice depend on numerous factors and parameters, and no specific mix proves to be consistently superior.

The blend of real estate and infrastructure is also controversial, but one study by the Norwegian Government Pension Fund Global suggests a maximum portfolio weighting of about 10% is sufficient for each. In crisis periods, this can be three or even four times higher.

Another important finding is that real estate and infrastructure may be more useful in terms of alleviating risk (the classic aim of diversification) than through actual returns. Given the controversy on effective asset allocation and the turbulence in real estate markets, this is a major issue. The latter highlights the benefits of using not only real estate but also infrastructure.

Also significant is the revelation that the targeted rate of return impacts the appropriate level of real estate. Investors with higher portfolio return targets (who wish to earn more, but with more risk), may wish to devote less to real estate and infrastructure. This depends a lot on the state of these markets in relation to the equity markets in terms of whether the latter is in an upward or downward phase.

The Bottom Line

Both real estate investment and infrastructure can play a vital role in optimizing portfolios. The exact allocations to real estate and infrastructure depend on various parameters. Apart from the expected rate of portfolio return mentioned above, there is also the issue of how risk is defined. Other relevant factors include attitudes towards infrastructure in general, and how this relates to other alternative investments.

In practice, these allocation decisions are complex, and higher or lower optima are therefore possible for different investors at different times. If there is one thing that remains the top priority for all investors—especially risk-averse ones—it's having a well-diversified portfolio.