Within Real Estate, apartments have historically presented the best risk-adjusted returns
If you have taken a finance or capital markets class at nearly any level, one of the most significant lessons they will have discussed, the lesson that underpins nearly every other concept in finance, is that Investors demand to be paid for risk, and in an efficient market if you want higher returns, you must take higher levels of risk. As the concept goes, if an investor can get higher returns for lower risk, then enough investors will invest in that investment to drive down the returns until it is in line with the expected risk-return premiums of the market.
As such, in an efficient market, a chart like the one above should never exist. The chart above, which shows risk vs. standard deviation for private market real estate investments, indicates that the highest-returning asset class is also one of the lowest-risk ones and that this has been the case for nearly the last 40 years. That asset class is Apartments. While we are not economists, and thus can only speculate why efficient markets have broken down in private real estate investments (likely the presence of information efficiencies and lack of market access coupled with demand for real estate investment outpacing capital supply, particularly in the residential space); what we can do is look a few drivers of high returns and low risk in the apartment space, which we believe will lead to a continuation of this trend for years to come.
Drivers of Outsized Apartment Returns:
Shorter Lease Terms: Apartments have shorter lease terms than other investment types, allowing landlords more frequent opportunities to reset rents to match market changes. This also removes the holdout problem associated with longer leases and thus requires landlords to spend less on buildout
Product Differentiation: While other real estate types such as office, industrial, and retail compete on location, their primary differentiator is cost. Apartments cater to individuals, who tend to have nuanced living preferences and, therefore, compete more on design and offering than on price
Lower Tenant Leverage: With a more diversified tenant base, individual tenants have less leverage and, therefore, less ability to negotiate lease terms
Lower OPEX: With less common space and the ability to bill back the majority of expenses and any damage to tenants, apartments tend to have lower OPEX costs than other property types
Drivers of Reduced Apartment Risk:
Supply/Demand Imbalance: As the nation has experienced historical population growth, residential has seen the largest supply-demand imbalance of any property type, lowering rent volatility
Diversified Tenant Base: With the most diversified tenant base, apartments avoid the vacancy risk associated with losing an anchor tenant, which is prevalent in other property types