Beating the Benchmarks: How to Achieve Resilient Alpha

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The post-pandemic era has been unkind to real estate investors, as the combination of unrelentingly high interest rates, persistent working-from-home, and an e-commerce plateau has left both commercial and residential markets teetering on the edge of recession.

Not that their performance was much better before these disruptions. Real estate as an asset class has lagged the overall market, delivering five-year average annual returns between 3% and 7%, while real estate ETFs have hovered around just 3%. With occupiers shedding office space in gateway markets while formerly white-hot industrial properties cool, investors would clearly benefit from novel forms of geographic- and asset selection to achieve far higher returns.  

This is doubly true once climate change is taken into account. Current real estate structured products and indices possess significant exposure to climate-stressed areas in the United States, suggesting longer-term returns will suffer from risk-adjusted impacts. Climate Alpha’s research on more than 140,000 U.S. properties across more than 700 REITs found a sizable portion have substantial exposure to physical climate risks such as fires, floods, and storms. (Ironically, real estate ESG indices purporting to be “climate aligned” have performed even worse due to a lack of financial materiality in considerations such as GRESB scores and green building certifications.)

For investors struggling to construct alpha-generating, climate-aligned portfolios, Climate Alpha offers solutions, tools, and data grounded in our “spatial finance” approach to drive resilient outperformance. Spatial finance is predicated on the idea that location, the environment, and economic outcomes are intertwined. We believe investors can achieve significantly more upside using the differentiated and climate-aligned selection criteria our model provides.

We employ pattern-seeking machine-learning models to identify benchmark-beating locations and assets that might escape financial analyst using traditional research and analytical methods. We then cross-check these locations against our proprietary Resilience Index™ to ensure climate alignment. Beyond physical risk exposure, we model impacts of second-order effects such as supply chains, insurance premiums, investment shifts, infrastructure investment, migration patterns, loan delinquencies, and more.

For example, in an experiment comparing REIT performance against an ideal benchmark portfolio composed of top to top-performing locations between 2016-2021, we found that: 

1. There is significant upside potential in constructing real estate investment vehicles with better geographic- and asset selection.

Our hypothetical Climate Alpha portfolio comprising properties from the 200 highest-performing ZIP codes across 20 major metropolitan areas delivered a five-year return of 78.99% and a 10-year return of 166.77% compared to a national average of 37.58% and 59.92% respectively. There is clearly room for improvement. 

2. Investors willing to buck consensus could have achieved higher returns in overlooked locations.

While REITS are overly concentrated in central business districts and other prime locations, in certain locations the top performers are located outside the center and popular sub-markets — such as Tacoma, Washington and Jefferson, CO in metropolitan Seattle and Denver, respectively.

3. In top-performing locations such as Florida and Los Angeles, investors can discover additional upside in overlooked areas.

The best returns to be found in greater Los Angeles, for example, are to be found in the Antelope Valley north of the San Gabriel mountains, where communities such as Palmdale and Lancaster have seen explosive growth in a search for affordability. Meanwhile, the best areas in the Tampa Bay area lie in outlying Hernando County, 50 miles north of Tampa proper.

4. Some markets are popular destinations for investors but lack any top performers — while others possess desirable locations where REITs are absent


For the identity of these locations as well as areas with high concentrations of both climate- and home foreclosure risks, enter your information to download the full article.

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