As real estate portfolio managers and REITs make acquisition decisions, consciously or not they also decide how operationally efficient their portfolios will be. And investors take notice.

Equity Residential spent $1 billion in a single deal last year to grow in three of its existing markets. Intuitively, we all assume having multiple assets in any single market drives operational efficiencies, so that checks out. But we also intuitively know diversification is a portfolio priority as well - too much geographic clustering means too much idiosyncratic risk. Imagine if Equity Residential only owned assets in Austin.

What’s the right amount of portfolio diversification? It turns out we can do more than intuit the right answers thanks to academics Daniel Huerta and Christopher Mothorpe.¹

Their research, while not prescriptive, shows clearly that moderate property clustering drives meaningful improvements in both operational efficiency and firm value for REITs. Portfolio construction that prioritizes a regional clustering strategy is optimal. Although the researchers don't say exactly how many properties make an optimal cluster, they clearly say it's important to avoid the extremes of very high or low clustering and one should avoid owning a single asset in any market.

They are also clear about the geographic boundaries of a cluster: The sweet spot appears to be a group of assets within a 50 to 75-mile radius. Within that range, firms get optimal economies of scale, cost efficiencies, and actionable market intelligence. Specifically, that size of a footprint enables landlords to streamline property management and leasing operations and drive better staffing allocations and service quality. Vendors and contractors can also be engaged more efficiently.

Interestingly, clustering also helps mitigate the “geographic diversification discount,” a known phenomenon in which REITs that expand their portfolios geographically see firm value decrease, all else equal. The researchers' findings suggest this discount can be minimized and even alleviated with the operational benefits a portfolio enjoys from moderate clustering.

A final thought: Despite the data, portfolio managers approach clustering differently. EQR is a serious clusterer. They have 312 assets in 13 US markets, and four of those markets are in southern California. They own zero apartments in Chicago, Houston, Philadelphia, Miami or Phoenix, all top-10 US cities by population.

Equity is the second-largest residential REIT, behind AvalonBay, which takes a different approach. AVB has about 305 properties (excluding those in development) in literally dozens of cities. Another residential REIT, Mid-America Apartments, talked about clustering recently, saying in their most recent earnings call they’ll be exiting “markets where we have one or two assets” and growing in the company’s “newer markets” like Denver and Salt Lake City.

The Rake

The week's three most not bad articles.

• Private Credit is Going Public via New ETF - Reuters

  Wall Street's latest innovation is here: a private credit ETF. State Street and Apollo have teamed up to launch PRIV, an actively managed fund that blends public and private credit, aiming to democratize access to a traditionally exclusive asset class.

• Small Bay Optimism Amid Increased Scarcity - WSJ($)

  The small warehouse crunch is real, and it's getting tighter. Despite an overall rise in warehouse availability, businesses seeking spaces under 100,000 square feet are facing a severe shortage.

• ‘We are Definitely on the Offensive’ - BisNow

  Bain Capital Real Estate is betting that a risk-on approach to equity, coupled with careful management, is the key to unlocking returns in today's complex real estate landscape, even if it means a "long fight" to work through the lingering market stress.

The Harvesters

Each week one new sponsor doing something you should know about.

Who: Backflip

What: A platform focused on providing loans and digital tools to local fix-and-flippers focused on renovate-to-rent single-family homes. Raises funds from capital partners to own loan pools and portions thereof that it originates.

The Sparkle: Expanding quickly amongst professional-but-not-sophisticated local housing investors who need access to appropriately priced debt and who can drive productivity with Backflip's tools and processes. This market segment has remained robust despite the rise in interest rates; Backflip’s loan originations are growing quickly.

Quote (customer-facing): "With fast analysis, tailored loans, and a smoother funding process, Backflip gives you the confidence and the cash to close your next great property deal."

From the Back Forty

A little of what’s out there.

What designers create, photographers make timeless. A nice reminder of beauty in the details.

Link: https://divisare.com/authors/2144617305-adam-mork

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1  Huerta, D., Mothorpe, C. The Impact of Property Clustering on REIT Operational Efficiency and Firm Value. J Real Estate Financial Econ (2024). https://doi.org/10.1007/s11146-023-09973-w