We’re thrilled to share our newest piece of thought leadership that contributes to the research and best practices that shape our industry.
The article explores vertical integration, a growth strategy where a company engages in multiple stages of the value chain — an approach Avenue Living has taken since 2006. Few studies have examined the effects of vertical integration in real estate. We aimed to fill that gap by surveying 1,251 renters in the U.S., the U.K., and Canada, exploring their perceptions of property managers’ downstream vertical integration and effectiveness. The results show that property managers’ vertical integration enhances their overall effectiveness, as perceived by their residents, leading to better residents, sustained real estate performance, and an overall competitive advantage.
This commentary and the information contained herein are for educational and informational purposes only and do not constitute an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This article may contain forward-looking statements. Readers should refer to information contained on our website at https://www.avenuelivingam.com/forward-looking-statements for additional information regarding forward-looking statements and certain risks associated with them.
Our team is relentlessly committed to understanding our customers. Through this ongoing process, we have developed the knowledge required to tailor our assets and business model to best fit their needs. This approach is proven to enhance resident loyalty, build trust, increase pride in rental homes, and boost commitment to paying rent on time.
Research shows a market-oriented approach is imperative for residential property management seeking better residents and results. Read more in the peer-reviewed article from Gabriel Millard, Cameron Hills and Grant A. Wilson, published in Property Management journal.
This commentary and the information contained herein are for educational and informational purposes only and do not constitute an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This article may contain forward-looking statements. Readers should refer to information contained on our website at https://www.avenuelivingam.com/forward-looking-statements for additional information regarding forward-looking statements and certain risks associated with them.
This commentary and the information contained herein are for educational and informational purposes only and do not constitute an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This article may contain forward-looking statements. Readers should refer to information contained on our website at https://www.avenuelivingam.com/forward-looking-statements for additional information regarding forward-looking statements and certain risks associated with them.
Grant Alexander Wilson, Ph.D., Assistant Professor, Faculty of Business Administration, University of Regina
Jason Jogia, MBA, M.Fin., Chief Investment Officer, Avenue Living
Author Bios
Dr. Wilson is an Assistant Professor at the Hill and Levene School of Business, University of Regina. His research focuses on marketing, strategy, and innovation. He has published over 20 peer-reviewed articles in top management journals including Journal of Small Business Management, Research-Technology Management, and Journal of Business Strategy. His research has been featured in the National Post and by the World Economic Forum. Dr. Wilson is also a research consultant and contributor to Avenue Living Asset Management.
Mr. Jogia is the Chief Investment Officer at Avenue Living and has over 15 years of experience in real estate capital markets, originating over $10 billion in real estate loans and $1 billion in equity. He has extensive experience in real estate investment analysis and capital structure across various real estate classes. In addition to holding 2 Masters’ degrees in Finance, Mr. Jogia is pursuing his Doctorate of Business Administration and currently serves as an instructor at the University of Calgary, specializing in real estate finance.
INTRODUCTION
The global pandemic caused the Government of Canada to have an “all hands on deck” approach to its intervention in the free market economy. Specifically, the Government of Canada enacted both expansionary fiscal and monetary policies. Fiscal policy “consists of changing government expenditure and/or taxes” (Lumsden, 2011). In contrast, monetary policy “consists of changing the money supply or interest rates” (Lumsden, 2011). The pandemic stimulus package (government expenditure) was the largest on record (Wilson, 2021), equating to 11.2% of Canada’s gross domestic product (GDP), 420% larger than the 2008 recession (McKinsey, 2020). Other fiscal policies to expand the economy included a number of new tax exemptions and deferrals for both individuals and businesses (Government of Canada, 2021). In the early weeks of the pandemic, interest rates were reduced (expansionary monetary policy) to record-breaking lows (e.g., 0.25%) (Bank of Canada, 2022a; Foran, 2020). According to the Bank of Canada (2022a), “lowering interest rates [was] the Bank’s best-known tool to encourage borrowing to stimulate the economy.” Simply, in times of low interest rates such as the pandemic, economic actors are more likely to borrow money and make large purchases, increasing the overall demand for money (Investopedia, 2021).
Figure 1 illustrates how the lowering of interest rate (I1 to I2) results in a movement along the money demand curve (MD). In order to establish equilibrium between the money demanded (MD) and supplied (MS), the money supply needs to increase (MS1 to MS2).
An effect of increasing the money supply too quickly is inflation (Ross, 2021; Lumsden, 2011). While “the natural tendency of the state is inflation” (Rothbard, 1962), Canada is currently experiencing above-average inflation (> 2%) (Trading Economics, 2022; Wilson, 2021; Wilson, 2022). Specifically, in June of 2022, Canada’s annual inflation rate was 8.1%, the highest since 1983 and well above forecasted figures (CNBC, 2022; Trading Economics, 2022) (Figure 2).
FIGURE 2 – INFLATION IN CANADA
Trading Economics (2022)
In response, the Government of Canada has committed to a series of interest rate increases (contractionary monetary policy) to “forcefully” curb inflation (Bank of Canada, 2022b). This paper explores the macroeconomic implications of interest rate increases. Specifically, the relationships between interest rates and the stock market, home values, and residential rents are examined.
INTEREST RATES & THE STOCK MARKET
According to Hall (2022), changes to the interest rate “impacts both the economy and stock markets because borrowing becomes either more or less expensive for individuals and businesses.” Interest rate increases, such as those occurring now and in the foreseeable future, “negatively affect earnings and stock prices” (Hall, 2022). An examination of the TSX Composite Index (benchmark measure of the Canadian stock market) and historical variable mortgage interest rates (a measure of real-time consumer interest rate changes) exemplifies this inverse relationship (Figure 3).
FIGURE 3 – TSX & VARIABLE MORTGAGE INTEREST RATES
Stock Performance (2022) & Super Brokers (2022)
Given the inverse relationship between the stock market and interest rates, recent and committed rate hikes have investors concerned, anticipating a recession, and seeking alternative investments. Real estate positions have been characterized as alternative investments that possess inflation-hedging benefits (Hartzell et al., 1987; Hoesli, 1994; Lee & Lee, 2014; Nickerson, 2021; Rubens et al., 1989; Wilson, 2021; Wilson, 2022). However, not all real estate investments react similarly – as they do with inflation – to interest rate increases.
INTEREST RATES & HOME VALUES
Interest rates and home values are central to homeownership affordability. According to Nielsen (2022), “interest rates are important to the housing market for several reasons. They determine how much we will have to pay to borrow money to buy a property, and they influence the value of [homes].” Low interest rates increase the demand for homes and increase prices, whereas high interest rates decrease the demand for homes and lower prices. A comparison of Canada’s historical overnight rate and new house price index (a proxy for home values) from 1990 to 2022 illustrates this relationship. As interest rates decrease, the new home price index increases (Figure 4).
FIGURE 4 – INTEREST RATES & HOME VALUES
Bank of Canada (2022) & Statistics Canada (2022)
A regression analysis, using interest rate as the independent variable and the new house price index as the dependent variable, confirms that the two are negatively correlated (β =-.713, p < 0.001). This demonstrates that as Canadian interest rates decreased, home values increased. In contrast, as interest rates increase, home values are expected to decrease. Given their “strong” negative correlation (r > ±0.40) (Hair et al., 2000), future interest rate increases are likely to create lower demand for homeownership in Canada, resulting in a “flight to affordability” or renting.
INTEREST RATES & RESIDENTIAL RENTS
A demand curve is a graph that depicts the relationship between the price and quantity of a good or service (Lumsden, 2011). Moves along the demand curve show how the quantity demanded changes at every level of price (Lumsden, 2011). A shift of the demand curve occurs when a variable, not on the axes, changes (Lumsden, 2011). In real estate, increasing interest rates and lower demand for homeownership increases rental demand at all levels, shifting the entire demand curve up and to the right (DR1 to DR2) (Figure 5).
FIGURE 5 – RENTAL DEMAND
The shift isempirically validated. However, unlike the conceptual illustration, in reality, the shift is somewhat lagged. Comparing Canada’s variable mortgage interest rate with the inflation-adjusted rental price index (a proxy for multi–family residential rents) shows that as mortgage interest rates increase or decrease, residential rents experience lagged corresponding increases or decreases (Figure 6). Given that the rental price index is inflation-adjusted, it can be concluded that these changes are direct responses to rental demand fluctuations.
It is evident that multi-family residential properties have distinct advantages in an increasing interest rate environment. As interest rates increase, more individuals are contemplating renting. At the same time, new multi-family construction slows down due to the cost of borrowing. The increased demand, but stagnant supply, puts upward pressure on residential rents. For savvy investors seeking to preserve and grow wealth, it may be strategic to include or expand multi-family residential real estate positions. Currently, wealth preservation is top of mind, as big banks and economists are forecasting an impending recession (Tepper, 2022; Ray, 2022).
GROSS DOMESTIC PRODUCT (GDP) & RESIDENTIAL RENTS
Gross domestic product (GDP) is a comprehensive assessment of a country’s economic health, as it measures its total domestic production. Increasing GDP, over two periods, is known as economic growth or a boom. In contrast, declining GDP over two consecutive quarters is defined as a recession. Comparing the annual changes of Canada’s GDP (booms and recessions) with changes to inflation-adjusted residential rents shows an inverse relationship (Figure 7).
FIGURE 7 – RENTAL PRICES & GDP
Statista (2022) & World Bank (2022)
A regression analysis, using GDP as the independent variable and rental prices as the dependent variable, shows that the relationship is negative (β = -0.756) and statistically significant (p = 0.007). This suggests that in times of GDP decline, inflation-adjusted residential rents (real increases to rent) experience the largest growth, supporting multi-family residential real estate as a recession-proof investment.
WHERE TO NEXT?
The last two years have been anything but stable and predictable. As a result, individual and institutional investors have had – to say the least – a “bumpy ride.” Understanding that the Bank of Canada is increasing interest rates and will continue to engage in contractionary monetary policies to curb inflation, it is a precarious time for investors. Examining historical data that compares rising interest rates with the stock market and home values emphasizes the importance of alternative investments that perform well in times of rising interest rates, namely multi-family residential real estate. As the world economies face increasing interest rates and impending recessions, this real estate asset class offers significant advantages.
Lee, C. L., & Lee, M. L. (2014). Do European real estate stocks hedge inflation? Evidence from developed and emerging markets. International Journal of Strategic Property Management, 18(2), 178-197.
Lumsden, K. G. (2011). Economics. Edinburgh Business School Heriot-Watt University.
Grant Alexander Wilson, Ph.D., Assistant Professor, Faculty of Business Administration, University of Regina
Jason Jogia, MBA, M.Fin., Chief Investment Officer, Avenue Living
Author Bios
Dr. Wilson is an Assistant Professor at the Hill and Levene School of Business, University of Regina. His research focuses on marketing, strategy, and innovation. He has published over 20 peer-reviewed articles in top management journals including Journal of Small Business Management, Research-Technology Management, and Journal of Business Strategy. His research has been featured in the National Post and by the World Economic Forum. Dr. Wilson is also a research consultant and contributor to Avenue Living Asset Management.
Mr. Jogia is the Chief Investment Officer at Avenue Living and has over 15 years of experience in real estate capital markets, originating over $10 billion in real estate loans and $1 billion in equity. He has extensive experience in real estate investment analysis and capital structure across various real estate classes. In addition to holding 2 Masters’ degrees in Finance, Mr. Jogia is pursuing his Doctorate of Business Administration and currently serves as an instructor at the University of Calgary, specializing in real estate finance.
INTRODUCTION
Diversification is synonymous with “not putting all your eggs in one basket.” If the basket drops, all of the eggs break. Therefore, placing eggs in multiple baskets – the act of diversifying – reduces such risk. The concept of diversification has a long history in finance and portfolio management (Markowitz, 1952). Diversification is a strategy that aims to reduce risk through the inclusion of multiple and differing investments. “The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security” (Segal, 2021). This paper first explores modern portfolio theory, the mechanics of how diversification reduces risk. Next, it examines the importance of diversifying portfolios with real estate investments and diversification within real estate portfolios for institutional investors. Last, the paper explores the limitations of diversification and advantages of specialization for small real estate owners/operators. It concludes by offering strategic directives for real estate investors.
MODERN PORTFOLIO THEORY
Developed 70 years ago by economist Harry Markowitz, modern portfolio theory can hardly be considered “modern.” Despite its age, modern portfolio theory’s relevance is timeless, as it offers a framework for designing portfolios that maximize return and minimize risk (McClure, 2021). According to Markowitz (1952), an investment’s risk comprises systematic and unsystematic risks. “A systematic risk is one that influences a large number of assets, each to a greater or lesser extent” (Ross et al., 2007). Systematic risks are also called market risks (e.g., recession) and cannot be eliminated by diversification (McClure, 2021). Conversely, “an unsystematic risk is one that affects a single asset or small group of assets” (Ross et al., 2007). Unsystematic risks are also known as asset-specific risks (e.g., supply shortage of a company’s input) and can be reduced through diversification. Markowitz (1952) argues that overall portfolio risk can be reduced to a certain point by diversification, as the inclusion of investments that do not move proportionally in the same direction at the same time eliminate unsystematic risk (Figure 1).
FIGURE 1 – MODERN PORTFOLIO THEORY
Sources: McClure (2021), & Ross et al. (2007)
Although modern portfolio theory was quickly and heavily embraced in the stock and bond markets, its application to real estate was much slower (Viezer, 2010). Only in the 1980s were diversification and modern portfolio theory applied to real estate. Today, savvy investors both diversify portfolios to include real estate and diversify within real estate investment portfolios.
DIVERSIFYING WITH REAL ESTATE
Miles and McCue (1984) were the first to show that real estate investments were significantly correlated with inflation, providing support for real estate as an investment hedge. Miles and McCure’s (1984) findings are highly relevant today, as recent examinations show that capital appreciation of real estate assets outpaces inflation (Wilson, 2021). Researchers have also shown that real estate investments have low correlations with stocks and bonds (Miles & McCue, 1982; Miles & McCue, 1984; Robichek et al., 1972; Viezer, 2010; Zerbst & Cambon, 1984), making them ideal for diversification (Markowitz, 1952; Ross et al., 2007).
The question of how much real estate to include in an investment portfolio has been widely debated (Firstenberg et al., 1988; Fogler, 1984; Giliberto, 1992; Hartzell, 1986; Irwin & Landa, 1987; Kallberg et al., 1996; Webb et al., 1988; Webb & Rubens, 1987; Viezer, 2010; Ziobrowski & Ziobrowski, 1997). Hartzel (1986) recommended smaller real estate investment allocations, such as 3% to 11%. Kallberg et al. (1996) and Giliberto (1992) offered similar recommendations of 10%. Firstenberg et al. (1988), Folger (1984), and Irwin and Landa (1987) argued that portfolios required 15% to 20% of real estate investments to achieve maximum diversification benefits. Ziobrowski & Ziobrowski (1997) concluded that 20% to 30% of an investment portfolio was necessary to realize the greatest return. Others have suggested that the majority of one’s portfolio should be comprise of real estate investments (Webb et al., 1988; Webb & Rubens, 1987). Despite the contrasting empirical evidence, research overwhelmingly supports the inclusion of real estate in portfolios to reduce risk and increase return (Viezer, 2010).
To illustrate, an examination of changes to home prices, land values, stocks, and bonds illustrates the benefits of Canadian real estate (Figure 2).
FIGURE 2 – ANNUAL CHANGES TO CANADIAN REAL ESTATE, STOCKS, & BONDS
Sources: Bank of Canada (2022), Farm Credit Canda (2021), Statistics Canada (2022), Yahoo Finance (2022)
The new house price index – a measure to assess changes to home prices in Canada – has shown consistency and strong year-over-year appreciations, particularly from 2019 to 2021 (Statistics Canada, 2022). Annual changes to Canadian farmland values have also been favorable and consistent, ranging from 4% to 8% in the period examined (Farm Credit Canada, 2021). In contrast, the S&P/TSX composite – the benchmark Canadian stockmarket index – has shown double-digit returns but also extreme volatility from 2016 to 2021 (Yahoo Finance, 2022). Over the last several years, Canada’s 10-year government bond has offered stability, but at the expense of nominal returns (Bank of Canada, 2022).
The risk and return benefits of real estate – demonstrated by past empirical examinations and in the above depiction – emphasize the need to include real estate in investment portfolios for diversification. According to Viezer (2010), “first decide the optimal allocation of real estate to a multiasset portfolio, and then decide how to diversify within the real estate portfolio.”
DIVERSIFYING WITHIN REAL ESTATE
Researchers have debated the most effective means to diversify real estate portfolios, as unsystematic risk can be reduced by property type, geographic, and financial diversification (Anderson et al., 2015; Benefield et al., 2009; Campbell et al., 2003; Cici et al., 2011; Cronqvist et al., 2001; Gobbi & Sette, 2014; Gyourko & Nelling, 1996; Hartzell et al., 2014; Ioannidou & Ongena, 2010; Ro & Ziobrowski, 2011; Santos & Winton, 2008).
According to Miles and McCue (1982), property type diversification offers the greatest return and the lowest risk. This has been replicated in studies of real estate investment trusts (REITs). Benefield et al. (2009) and Row and Ziobrowski (2011) show that diversified REITs outperform specialized REITs. Anderson et al. (2015) corroborate these findings, showing that diversified REITs have a “strong positive relationship” with return on assets, return on equity, and Q ratios (market value to asset replacement cost). Anderson et al. (2015) explain that “the diversification benefit comes from both the ability to select better-performing property types in ‘hot’ markets and the limited exposure to poorly performing property types in ‘cold’ markets” (p. 48). In addition to property type diversification, diversifying with private or public REITs has its advantages. According to Blackstone (2022) and Wang (2021), private REITs generally increase in times of rising interest rates and have less volatility, as compared to public REITs. As such, unsystematic risk can be reduced by REIT type (e.g., public/private) and property type (Gyourko & Nelling, 1996).
There is a significant body of research that shows the benefits of geographic diversification (Campbell et al., 2003; Cici et al., 2011, Cronqvist et al., 2001; Feng et al., 2021; Hartzell et al., 2014; Jud et al., 2021; Oertel et al., 2019). Hartzell et al. (1987) argued that diversification based on geography was strategic, given the performance benefits. As with property type diversification, geographically diverse REITs have been shown to outperform geographically concentrated REITs. According to Feng et al. (2021), “geographic diversification is associated with higher REIT values for firms that can be described as being more transparent” (p. 267). Recent work by Jud et al. (2021) and Oertel et al. (2019) adds to such geographic diversification research, showing international acquisitions offer enhanced portfolio returns.
Grissom et al. (1987) acknowledged the performance benefits of diversifying by both property type and geography. In fact, this research showed that diversification “across markets and property type reduced unsystematic risk more than across just markets or across just property types” (Viezer, 2010). Accordingly, Grissom et al.’s (1987) research supported the combination of property type and geographic diversification to reduce risk and increase returns. A lesser-explored area of research suggests that financial diversification may also reduce unsystematic risk among real estate investments.
There is an inherent risk in concentrated borrowing. According to Gobbi and Sette (2014), in times of crisis concentrated borrowing is detrimental to a firm’s access to credit. Moreover, Ioannidou and Ongena (2010) find that interest rates increase for clients over time and companies can negotiate better deals in new relationships with different banks. Therefore, it is strategic for real estate companies to diversify their borrowing to reduce unsystematic risk and negotiate better interest rates.
It is evident that diversification with and within real estate (e.g., property type, geography, and financial diversification) is necessary to maximize returns and minimize risk, but can endless diversification reintroduce risks?
OVER-DIVERSIFICATION & SPECIALIZATION
When strategically executed, diversification is a proven method to reduce risk and increase return (Allison, 2021). However, it is possible to over-diversify. Investments that are not strategically motivated are unadvisable (Olgun, 2005), as they add unnecessary risk to the portfolio without the added upside (Allyson, 2021). Lynch (1989) coined this phenomenon of worsening the risk and return tradeoff of an investment portfolio by over-diversifying as “diworsification.” This paper argues that the real estate diversification and performance relationship is curvilinear, similar to other strategies (Bhuian et al., 2005; Oswald & Brettel, 2017; Tsai et al., 2008). While diversification is necessary to reduce risk and increase return, beyond a certain level it can become detrimental to portfolio performance (Figure 3).
Diversification is also not advisable for new or small owners/operators. According to Kenton (2022), a specialization strategy focuses on limited scope and expertise for greater efficiency and performance. Specialization has been shown to create economies of scale, improve market positions, and enhance the bottom line of small businesses (Intihar & Pollack, 2012; Williams et al., 2018; Wilson et al., 2020). New or small real estate owners/operators are more likely to benefit from a specialization versus diversification strategy, as eliminating unsystematic risk is unlikely due to the small number of properties, geographic concentration, and individual property management. As these new and small owners/operators mature and expand, a diversification strategy becomes more advantageous and reduces their accumulated unsystematic risk.
STRATEGIC DIRECTIVES
So how much real estate diversification is enough, and how much is too much? Diversification with and within real estate is necessary for investors. However, Olgun (2005), aptly states that non-strategic real estate investments are problematic and often produce “negative abnormal returns.” Instead, when real estate investments are strategically included in multi-asset portfolios they increase return and reduce unsystematic risk (Miles & McCue, 1982; Miles & McCue, 1984; Robichek et al., 1972; Viezer, 2010; Zerbst & Cambon, 1984). Diversification within real estate is also required to eliminate unsystematic risk and realize the greatest level of return (Grissom et al., 1987; Hartzell et al., 1987; Jud et al., 2021; Miles & McCue, 1982; Oertel et al., 2019, Viezer, 2010). As Grissom et al. (1987) suggest, the best results come from combined diversification methods (e.g., property type and geography). It is further argued that financial diversification can also help reduce unsystematic risk and lower borrowing costs. In the context of Canada, investment portfolios that include residential real estate and farmland as core assets appear to both enhance value and offer stability. Diversification within these real estate investment categories, such as the types of residential real estate and various Canadian sub-markets, are also likely to enhance the overall portfolio of investors. As Peter Bernstein, one of the most prominent American economists wrote, “diversification of risk matters not just defensively, but because it maximizes returns as well, because we expose ourselves to all of the opportunities that there may be out there.”
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This commentary and the information contained herein are for educational and informational purposes only and do not constitute an offer to sell, or a solicitation of an offer to buy any securities or related financial instruments. This article may contain forward-looking statements. Readers should refer to information contained on our website at www.avenuelivingam.com for additional information regarding forward-looking statements and certain risks associated with them.
Throughout our 16 years in the residential rental space, we’ve gained a deep understanding of our customer base and we use those insights to guide our decision-making and drive our organization’s growth. Since our inception, we’ve focused on the workforce housing resident and made it our mission to create a business model that serves their specific needs. Our operations and acquisition strategy are truly built around the preferences of this vital demographic we serve.
Our CEO and Founder, Anthony Giuffre, is actively involved in the academic side of the real estate industry and uses research and literature to explore the diverse demographics we serve and how we can continue to enhance our best-in-class customer experience.
In collaboration with Grant A. Wilson, Ph.D., and Assistant Professor in the Faculty of Business Administration at the University of Regina, this article illustrates a rental housing spectrum that goes beyond classifying renters by their length of tenancy and identifies lifestyle, demographics, and value propositions. Through this research, we have identified six distinct groups and the driving factors behind the type of rentals they choose.
This commentary and the information contained herein are for educational and informational purposes only and do not constitute an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This article may contain forward-looking statements. Readers should refer to information contained on our website at www.avenuelivingam.com for additional information regarding forward-looking statements and certain risks associated with them.
